Defined Benefit vs. Defined Contribution Pensions
When you retire, the value of a Defined Contribution pension completely depends on how much you have paid in and how well your investments have performed, much like any type of personal investment account.
In contrast, a Defined Benefit pension promises an income in retirement rather than a pot of money. This is calculated based on several factors, the first of which is the length of time you worked for the company.
The company will use the salary that you were earning whilst working for the company (most commonly, this will be your final salary, but some schemes will use an average of your salary over your entire period of employment) and factor that into the calculations. There is also something called the accrual rate, which is the proportion of your salary (average or final) you will get as an annual retirement income.
Understanding Defined Benefit Schemes
A key point to understand with Defined Benefit schemes is that your employer is responsible for ensuring that the scheme is sufficiently funded to fulfil the retirement income obligations it promises to you and its other members. If the company gets into financial difficulty and cannot fulfil that income promise, then the Pension Protection Fund (PPF) in the UK can step in and cover your pension income, but the outcome here will normally be that you receive a lower amount than your employer promised you.
Whilst a Defined Benefit scheme does not hold a live cash value in the same way as a Defined Contribution scheme does, a member can request a ‘Cash Equivalent Transfer Value’ to be calculated by the scheme if they wish to exit the DB arrangement and convert the benefits into a Defined Contribution type scheme or personally managed pension.
Transferring Defined Benefit Pensions
Deciding to transfer out of a Defined Benefit pension should not be done without professional advice and analysis. If the value of the pot exceeds £30K, legally advice has to be taken from a regulated financial adviser. There is a lot to understand and required procedures to complete before committing to an authorised transfer of what may well be an incredibly significant sum of money.
One of the first steps that will need to be taken will be to request the existing scheme to calculate the CETV (Cash Equivalent Transfer Value). This will effectively be a settlement offer from the scheme to convert your promised benefits into a cash value and make this available to you as an alternative to retaining the promised benefits of the DB scheme. Some companies will be keener than others to encourage members to transfer out of their scheme – which will play a part in dictating how ‘generous’ the cash offer is and how the calculation is made. Companies concerned about the scale of their long-term income commitment to members may elect to try and encourage members to transfer out to reduce their liability.
When Can You Transfer Out?
Defined Benefit pension transfers into Defined Contribution or personal pension plans can provide valuable financial planning opportunities in the right circumstances. Flexible access drawdown allows benefits to be taken earlier than most Defined Benefit schemes do, and many people will use this facility to withdraw their 25% tax-free lump sum (if they are at least 55 years old) and leave the remainder of their pension fund invested for use for income later.
For members who have settled outside of the UK as long-term expatriates, Defined Benefit pension transfers have additional factors which need to be considered and can make this a more logical action if there is a strong possibility that they will retire overseas.
It is essential to take advice from an authorised Pension Transfer Specialist (PTS) concerning DB transfers, and as a member, it is imperative to make sure you understand the following:
- The promised benefits that you will be giving up and the risks of doing so.
- How will the transfer fit in with your overall retirement planning
- How your retirement income expectations will be achieved and how this projection compares to the income that the DB scheme promised you is a crucial part of analysis that the PTS must work through with you.
Lifetime Allowance and DB Pensions
The lifetime allowance for most people is £1,073,100 in the tax year 2023/24. You would have paid a lifetime allowance charge on any pension savings over this amount in previous years. But from 6 April 2023, that charge has changed to 0%.
Withdrawing Money From Your Defined Benefit Pension
A Defined Benefit pension pays you an income in retirement, and your pension income increases yearly to consider the rising cost of living.
You can withdraw 25% of your pension as a calculated tax-free lump sum when you reach 55. If you choose to do this, the pension administrators will reduce the retirement income that you are being promised to reflect how much you have withdrawn from your pension as a lump sum.
When you die, a percentage of your pension can be paid to your surviving partner or dependents.
What Are Your Pension Transfer Options?
SIPP
A SIPP is a pension ‘wrapper’ that holds investments until you retire and begin to draw an income.
QROPS
A qualifying recognised overseas pension scheme (QROPS) is an overseas pension scheme that meets specific requirements set by HMRC.
