Defined Benefit Pension Scheme Advice And Transfer Options

How Do Defined Benefit Pensions Schemes Work?

Whether you have a final salary or a career average defined benefit pension, they’re both essentially a promise from a pension fund controlled by your employer to pay you an income for the rest of your life.

Both you and your employer pay into a defined benefit pension the same way that you and your employer would pay into a money purchase (or defined contribution) scheme.

However, instead of those funds going towards a pot of cash with your name on that you turn into a retirement income — usually by purchasing an annuity or entering income drawdown — a defined benefit pension has no specific pot of cash in your name.

It is simply a promise to pay you a retirement income until you pass away. Your contributions go into a defined benefit pension fund and, when you retire, that fund pays you an income, which is taxable at your highest marginal rate of income tax.

Defined Contribution Pensions vs Defined Benefit Pensions

The counterpart to a defined benefit pension is a defined contribution pension or money purchase pension. This is the type of pension most people are now saving into, especially those recently captured by auto-enrolment.

The main difference is that defined contribution pensions are a pile of cash you build up during your working life, whereas a defined benefit pension is a promise from an employer’s pension fund to provide you with an income from retirement until you pass away.

There’s no guarantee of an income with a defined contribution pension, unless you use it to purchase an annuity.

Defined Benefit Pension Calculator

How much your final salary pension is worth at retirement depends on three factors:

• Length of service with your employer and how long you’ve been contributing to the pension fund
• Pensionable earnings at retirement (for a final salary scheme this will be your retirement salary; for a career average pension this will be an average of your annual earnings across your career with that employer)
• Your pension scheme’s accrual rate (usually represented as a fraction, e.g. 1/80th, this refers to the proportion of your earnings you’ll receive as a pension for each year spent in the scheme).

When Can I Take My Defined Benefit Pension?

Most schemes have a normal pension age of 65, which means you’ll have to be 65 before taking a your final salary pension. A few schemes may allow you to take benefits as early as 55, but this could significantly reduce the amount you get.

If you want to work past your defined benefit pension’s normal retirement age, you may be able to defer claiming your pension. Alternatively, with some pension plans they may allow you to take your pension without retiring.

All of these factors are up to the discretion of the scheme administrator and your individual pension fund’s rules, so there’s no hard answer as to when you can take your defined benefit pension.

Can I Take A Lump Sum From My Final Salary Pension?

When you retire, you can technically receive up to 25% of your defined benefit pension savings tax-free. However, it’s important to realise that taking a defined benefit pension lump sum will reduce your annual pension benefit.

The monetary impact of taking a lump sum from your defined benefit pension is complicated to work out. It depends on what’s known as your pension fund’s commutation factor, which represents how much of a lump sum you’ll receive for every £1 you give up in income. A commutation factor of 10 means you’d receive a lump sum of £10 for every £1 of final salary annual income you choose to sacrifice. You will need to contact your pension scheme administrator to find out what yours is.

Can I Transfer Out Of Defined Benefit Pension Schemes?

Final salary pension transfers are possible. This sees you leave your defined benefit pension scheme in exchange for a pot of cash invested in a defined contribution pension.

A final salary pension transfer is unlikely to be in the interests of most people, but for the minority for whom it is an option, a transfer means you then have all of the benefits associated with having a defined contribution pension following the introduction of the April 2015 pension freedoms. Of course, along with those benefits comes the downsides to no longer having a defined benefit pension, such as the loss of a guaranteed income for the rest of your life for you and typically your spouse.

What Is A Cash Equivalent Transfer Value?

A cash equivalent transfer value or CETV is the technical term for the lump sum you’ll be offered to leave your pension scheme and cut ties with the plan for good, forfeiting the right to any future income from the scheme.

The pension transfer value you receive will vary depending on your employer and a variety of other factors, so it’s essential to ensure you’re getting a good CETV before going ahead with a pension transfer. If not, then it may not make financial sense to transfer at all.

Can I Transfer Out Of My Public Sector Pension?

For public sector workers in unfunded pension schemes, it’s only possible in the rarest of circumstances to transfer out of your defined benefit scheme. It’s not possible to transfer the vast majority of public sector final salary pension schemes.

The exception may be if you’re transferring to another defined benefit scheme, particularly if it’s another unfunded public sector final salary scheme, but again this is very rarely permitted.

This is because public sector pensions have no fund behind them — they’re a promise from taxpayers.

The local government pension scheme is different because this is funded — you may be able to transfer out but, as with any final salary pension transfer, you’ve got to consider your options carefully to make sure it really is the best thing for you.

Moving Jobs And Leaving A Defined Benefit Pension Scheme

Historically, people tended to have a job for life. They’d work for a single employer throughout their working life and then retire. Here it made sense for employers to manage the pension fund on behalf of their employees.

However, today people change jobs more frequently and therefore may build up entitlements in several pension schemes, both defined contribution and defined benefit.

If you’ve left a company with a defined benefit pension scheme before you were due to retire, then your scheme administrator should have offered you a pension statement showing you how much benefit you’ve built up during your time in the scheme.

To compensate for the effects of inflation, this will generally be revalued every year.

If you’ve lost touch with your previous scheme administrator, consider tracing your lost pension. You can do this for free using the government’s free pension tracing service, or read more about how to find lost pensions here →

Benefits of Defined Benefit Pension Transfers

• Today’s transfer values that are being offered can be very high
  Defined benefit pensions have become expensive to provide, especially in today’s economic environment. As such, funds are offering many scheme members high pension transfer values to leave the scheme and remove liability for that member from their books
• Moving to a defined contribution pension can provide more flexibility
  The April 2015 pension freedoms mean a defined contribution pension is now a far more flexible retirement instrument. You can draw on it however you like, taking tax-free and taxable lump sums or deriving an income from it as you see fit. You can even split the fund, using some of it to purchase an annuity if you still wanted a guaranteed income
• Potential for investment growth
  You don’t benefit from future investment growth in your pension fund with a defined benefit scheme. That’s because your benefit is fixed at retirement, regardless of how well the underlying fund performs. If, on the other hand, the transferred defined contribution pension pot performs well, you may be able to afford to draw more income from it.

Risks of Defined Benefit Pension Transfers

When you leave a final salary scheme you are giving up a guaranteed income for life. You can’t undo a transfer, so you need to think carefully whether this is in your best interests.

A pension transfer makes you responsible for investing your pension and you’ll bear the brunt of any investment losses, which means your income could fluctuate in line with the markets.

You’ll also need to consider your future retirement needs, including factoring in your life expectancy.

If you only have a small defined benefit pension and you transfer it to a defined contribution scheme, you may find that with an option such as pension drawdown your money runs out too soon.

To combat the risk of your income drawdown pension pot running out, we have put together a Pension Drawdown Calculator to show you how long your pension might last, including how long your pension would last if you transferred out of a defined benefit pension scheme.

However, there’s no guarantee that your pension will stay the course after you’ve transferred it, whereas a final salary pension is an income for life.

It’s mandatory to get advice if your final salary scheme is worth more than £30,000. At Drewberry we’ll take a look at your pension scheme and your circumstances and provide financial advice accordingly, recommending whether or not a final salary pension transfer is the right thing for you.

Neil Adams
Pensions & Investments Expert at Drewberry

What Are The Pros And Cons Of Defined Benefit Pensions?

Advantages

• Guaranteed income for life
  Defined benefit pensions promise an income from retirement to death, no matter how long you live
• No investment risk
  Your annual benefit is guaranteed no matter how the underlying pension fund is doing (unless it collapses and becomes a ward of the Pension Protection Fund, although the PPF still pays you a pension in such a case)
• Inflation-proofed income
  The guaranteed income you can expect is usually index-linked to keep pace with inflation
• Widows’ / dependants’ pension
  Many schemes pay a reduced widows’ pension or dependants’ pension to spouses / dependants of deceased pensioners
• Ill health pension
  Some DB pension schemes won’t reduce your pension entitlement based on fewer years of contributions if you have to retire early due to ill health
• Enhanced income if you’re pensioned off due to ill health
  Many DB Funds enhance your benefit post-retirement if you’re seriously ill to reflect the fact that they’ll likely be paying the pension for fewer years
• Potentially greater lifetime allowance protection
  Pensioners face the pension lifetime allowance charge if they take benefits over £1 million. As there’s no pot of funds in your name, the lifetime allowance for DB pensions is calculated as 20 times your annual income, which may work out favourably compared to a DC scheme of a size that would provide a similar drawdown income to your DB pension income
• Beat the money purchase annual allowance
  Once you start taking benefits from a money purchase pension, you’re restricted to making just £10,000 a year in future pension savings, a limit you’re not subject to when you start drawing a defined benefit pension.

Disadvantages

• Risk from reduced life expectancy
  Even if you are entitled to a higher pension due to ill health retirement, you’ll receive far less back from the scheme if you die soon after retiring than someone who’s paid in the same amount as you but lives for 20 years after retiring
• Your pension is a fixed income
  Planning for tax with final salary pension income is tricky because there’s nothing you can do to alter it to minimise tax bills
• No flexible pot of cash to leave relatives
  Benefits from a deceased pensioners’ final salary scheme are typically restricted to a reduced pension for spouses and dependant children under the age of 23, received it as a taxable income
• No inheritance tax benefits
  There’s no inheritance tax to pay on a DC pension pot providing it’s still invested or in a drawdown fund, so it can be an incredibly tax-efficient way to pass wealth down generations
• No investment rewards
  While there’s no investment risk with a defined benefit pension there’s also no room to benefit from investment rewards as the underlying investments aren’t yours. Your benefit stays fixed (apart from potential inflationary increases) even if the underlying pension fund sees bumper returns
• Your pension depends on the health of your employer
  There have been a number of highly-publicised incidences of severely underfunded pension schemes at collapsed companies, with the most recent example perhaps being bankrupt department store BHS
• Retirement age is later
  While you can access your pension at 55 with a defined contribution plan, scheme retirement ages for final salary schemes are typically set at or near state pension age.

Which Companies Offer Defined Benefit Pensions?

Final salary pensions were once common, in fact making up the majority of all pension plans. Yet today few companies offer defined benefit pensions. It’s mostly restricted to the public sector and very large private firms as these generous, gold-plated pension promises have become more and more expensive to provide.

In recent decades we’ve seen a swathe of DB pension funds beset with issues of affordability and closing their doors to new members.

Some defined benefit pension schemes have collapsed entirely and become wards of the Pension Protection Fund, which the government set up in 2005 to insure against this very risk.

Should this happen to your pension fund, you’re subject to a strict cap on what you can expect in retirement income no matter what you may have been entitled to before your fund collapsed.

Public Sector Pension Schemes

With the public sector, the promise to pay DB pensions is usually made by central government. This is known as an ‘unfunded’ pension scheme because retirement income is usually paid to members out of general taxation rather than an actual pension fund. These include:

• NHS defined benefit pensions
• Teachers’ pension funds
• Army pensions (and other armed forces pensions)
• The police pension fund
• The civil service final salary scheme.

Your Financial Plan: Build A Better Future

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