Defined Benefit/Final Salary Schemes
A Defined Benefit (DB) pension plan provides a known level of retirement income from outset and is suitably more generous than a Defined Contribution (DC) pension where retirement income depends on the individual’s premium history, plan charges, investment returns and prevailing annuity rates at retirement. Because DB pensions provide a guaranteed return at the end of the funding period they have been widely used by many companies to provide an attractive benefit to their employees.
Most DB schemes provide benefits based upon 4 key elements:
- The length of the active pensionable service credited to a member of the scheme
- Pensionable salary
- The formula or rate of 'accrual' which is used with a member's service and salary to work out their pension
- The circumstances under which benefits are taken from the scheme i.e. retirement, early payment, early leaver, ill-health, death etc.
A DB pension scheme will use a formula to calculate a member's pension benefits using these elements. The formula and the definitions for each will be set out in the Scheme Rules. The two most common forms of DB scheme are:
- Final Salary Schemes - Pensions are based upon on 'final pensionable salary', which for preserved members is normally worked out over the years immediately before ceasing to be an active member of the pension scheme
- Career Average Re-valued Earnings schemes (CARE schemes) - Pensions are based upon the 'average pensionable earnings' throughout the whole of the time of being an active scheme member
Because both types of scheme use pensionable salary as one part of the formula in order to calculate pension entitlement, they are both commonly referred to as 'salary related' schemes, but there can be significant differences between the pension benefits provided by each scheme type.
The 'accrual rate' is the rate at which pension benefits are built up whilst a member of the pension scheme and is most commonly expressed as a fraction, such as 1/30th, 1/60th, 1/80th, 1/120th etc. The lower the bottom number, the better the pension benefit received for an equivalent amount of pensionable service.
A DB scheme can provide an income (commonly referred to as a pension) or an income and a lump sum. Many private sector schemes include the option which allows part of the pension to be exchanged for a tax-free lump sum payment. This is called 'commutation' of the pension. Some pension schemes, notably many in the public sector, automatically provide the tax-free lump sum in addition to the pension - although the pension part of the benefit will normally be lower.
Benefits will usually be payable to a member when they reach the scheme's normal pension age or normal retirement date. This is important as it is the date at which a member would normally have been expected to start to draw their pension benefits without needing the consent of the employer or the Trustees. Depending upon scheme rules, the member may also be entitled to receive benefits at other dates such as:
- Early retirement
- Retirement due to ill health
- Terminal illness
- Late retirement (where work continues beyond normal pension age)
The advantages of having a DB pension are:
- Guaranteed income for life
- Guaranteed death benefits
- Guaranteed increases in payment throughout life
- No involvement – apart from a couple of months prior to retirement, when you decide on either the maximum income or reduced income and a tax-free cash lump sum
- Great for individuals who want maximum guarantees with little risk and no involvement
The regulator, the Financial Conduct Authority (FCA), states that members should be wary of transferring their DB scheme to a new flexible pension and in most circumstances they will be better served by leaving it where it is.
However, the drawbacks of a DB pension are:
- For anyone retiring early there can be significant penalties
- On death, your pension generally reduces by 50% if you are married. If you are not married and have no dependents, it dies with you
- The value of the pension cannot be passed to non-dependent family
- It may not be possible to access your tax free cash now and defer the pension
Therefore, you could consider transferring if you would like to retire early or leave a legacy to pass down, have shortened life expectancy, or have debts to pay off. With careful tax planning your money could be passed down generations without inheritance tax.
Since 2015 there has been a legal requirement for anyone wishing to transfer a DB/Final Salary pension valued in excess of £30,000 to seek qualified advice.
With interest rates at historic lows, transfer values have reached historic highs due to the way they are calculated, and many companies are encouraging deferred members to transfer to reduce their long-term liabilities. This is a very complex area and independent professional advice is more vital than ever in optimising this crucial area of long-term financial planning.
Nicholas Aslam is a qualified Pension Transfer Specialist.
At Henson Aslam, we are experts in the field of DB Pension Transfers and run our own analysis system to help in the evaluation of whether a transfer is in your interests.