Archived Content: This content was published over one year ago and may now be out of date.
By Ryan Steward FPFS, Chartered Financial Planner
The world of pensions can be confusing, it’s fair to say. With so many rules, acronyms and numbers in just one pension letter it’s easy to get lost in it all. I wanted to cover some of the basics of what a Defined Benefit pension scheme is, along with some of the key terms and rules you’re likely to come across when you’re deciding what to do with them.
Defined Benefit (DB) pensions, otherwise known as Final Salary pensions, at their core are fairly simple. It’s a pension that once you’re in retirement will pay you a guaranteed amount of income for as long as you live. The income you receive will slightly increase each year so that your income is hopefully keeping pace with inflation. In addition, if you were to die but your spouse or dependent was still alive then they could expect to receive income from your DB scheme for as long as they lived as well, though typically at more like 50% of what you received. This benefit is commonly called a ‘dependent’s pension’ and the percentage your dependent receives does change from scheme to scheme, but typically ranges somewhere between 35%-60% of what you were receiving on death.
How Much Income Will I Receive in Retirement?
There are a number of factors that can determine how much retirement income you can expect to receive from your Defined Benefit pension, a few of the main driving factors are:
- How long did you work at the employer in question
- What was your salary when you worked there
When speaking with clients I like to give a simple example that explains these factors in more practical terms, as I find that can make it a little easier to understand. Let’s say you worked at an employer for 30 years, you were in their DB scheme throughout that time and you were earning an average of £30,000 per annum whilst you were. Let’s also say that it was a ‘60th’ scheme (more on this momentarily) – this would mean that for every 1 year you worked there you would accrue 1/60th of your £30,000 salary as DB pension income (which works out as £500 per annum DB income being accrued for each year).
So if you worked there for 30 years you’ll have accrued 30/60th’s (i.e. half) of your salary as a DB pension:
30/60th’s (i.e. Half) of a £30,000 salary = £15,000 per annum as a DB income in retirement.
Not all schemes operate ‘1/60th’ schemes, some are more generous and might offer 1/50th, and others might be more like 1/80th. Naturally the lower the number on the right of the fraction then the more generous that scheme is, because this means you’re accruing benefits at a faster rate for each year you work there. For instance to get half of a £30,000 salary as a DB pension in a 1/80th scheme you’d need to work there for 40 years (i.e. half of 80), instead of 30 years like in the example we used before.
Your Yearly Defined Benefit Scheme Statement
Most people typically get a DB pension statement each year. On the statement, you might see a quote for what pension you can expect to receive at your Normal Retirement Date. This date is based on you reaching the DB scheme’s ‘Normal Retirement Age’, the most common retirement age is 65, though with some it may be 55, 60, 67, etc. You can typically take your DB pension outside of this age, but if you take it earlier you will likely be penalised by way of having your DB income quote reduced, or if you take it later the DB scheme may even increase the amount you can receive as a bonus for deferring past your Normal Retirement Date.
On your statement you’ll likely see at least a couple of quotes, one is normally a quote based on taking just DB pension income, and another one likely shows a lower income but with the maximum amount of Tax-Free Cash (TFC) being paid as well. This is showing you in pounds and pence how much TFC you can get when you start receiving benefits from the scheme and the cost for taking that TFC – that cost coming by way of reducing down the amount of pension income you’ll receive for life. There’s no right or wrong answer for whether to take more income and less TFC or vice versa, it depends on each person’s needs for a tax-free lump sum.
An often undervalued element of a DB pension is the annual increases in income that are included. Given that most retirees can expect to live for 20+ years once they enter retirement this benefit can really mount up over time. For instance, if someone was retiring on £20,000 per annum today, if inflation averaged 3% per annum over 20 years they would need their income to be £36,415 in order for the purchasing power of their DB income to have kept pace with inflation by the end of 20 years.
The great thing about a DB scheme is that it’s guaranteed for you and your dependent (if applicable) which means that the stock markets can go up, down, or sideways, it doesn’t matter, your employer and DB provider have promised to pay you a level of income and they assume the associated investment risks for providing that income. Compare that to the other main type of pension scheme, which is a ‘Defined Contribution’ (or ‘DC’ scheme), these same guarantees very rarely exist in DC schemes. Instead, a pot of money is built up over time from contributions by you and/or your employer, and then once in retirement the retiree has to choose how they take benefits from the accumulated DC pot. This gives DC pensions the advantage of being more ‘flexible’ than their DB counterparts, but at the cost of having no pension guarantees. This means that if the underlying investments in the DC pension don’t perform as planned then the retiree might not be able to get as much income as they’d perhaps expected from their accumulated pot once in retirement.
Having guarantees in retirement can give peace of mind and security as you know exactly what income you’re going to get. But in some rare instances, some people may consider transferring their Defined Benefit pension across into a Defined Contribution pension.
On request, a DB scheme can typically inform a member what the value of their pension would be if it was transferred into a DC scheme at the cost of walking away their guaranteed DB retirement income. If you’re considering transferring then it’s worth hanging fire on submitting this request as the quote you’ll receive is normally only valid for 3-months, and an adviser will want to cover off some other key information before getting the ball rolling with requesting this quote. (Note: it’s mandatory to take financial advice when considering transferring a DB pension with a transfer value greater than £30,000).
So there we have it, a DB scheme at its core is a guaranteed pension income for life, you can live to the grand age of 100+ and be safe in the knowledge you’ve got a guaranteed income that will help you cover your bills throughout. For the majority of people staying in the DB scheme is the right thing to do, but if you want more information or guides on this or any other type of pension please feel free to contact me.
