DB or not DB?

One question that I often get asked “what type of pension do I have, and how does it work?” This question usually comes from those with a type of ‘Defined Benefit’ pension, such as a Teacher, Local Authority employee or a private sector employee who’s had the privilege of accruing benefits within a Final Salary pension scheme. These types of pension can often be the most confusing to understand and not everyone will be confident that they truly understand what benefit they will get at retirement.

Here I will explain the difference between a Final Salary pension and a Defined Contribution pension (often referred to as money purchase, or quite simply a Personal Pension Plan).

A final salary pension scheme - quite rare to be offered this days, particularly for new employees - is a pension scheme, offered through an employer, which guarantees to provide a level of income based on your length of service with that employer and your final annual salary (hence the term ‘final salary’ pension). Some more recent schemes, link the guaranteed pension at retirement to your average earnings over the lifetime of your career with that employer - these schemes are sometimes referred to as Career Average Related Earnings (CARE) schemes, but are based on similar principles to Final Salary schemes.

As an example, John has worked for his employer since 1992 and has been a member of his employer’s final salary pension scheme since July 1992. He is retiring in August 2020, having completed 28 years’ service. His salary over the last 12 months of his career is £40,000 and his scheme is on a 1/60th basis (this means he accrues 1/60th of his final salary for each complete year of service. A simple way of working out his pension entitlement is 28 years x 1/60th x £40,000, which equals a pension of £18,666.67 per annum. This will be based on John retiring at the scheme's normal retirement age and taking the full scheme pension. Early retirement and / or taking a Pension Commencement Lump Sum will reduce his annual pension entitlement.

If John’s pension scheme were a Career Average Related Earnings scheme, the average of his earnings over the 28 year period would be used in calculating his pension entitlement at retirement, rather than his earnings in his final year of employment.

One of the main benefits of a Final Salary pension scheme is that it guarantees a certain level of income in retirement, payable for life, which is good insurance in the event that you live longer than average life expectancy. Most schemes also provide annual increases in the pension payments, to keep pace with inflation, and there is also the possibility that the scheme will provide for a spouse or other dependant, through the payment of a reduced pension (for example 50% or 66% of your pension) on your death.

Final Salary pensions can be costly to run, hence the reason why not many employers offer access to them any longer. The company takes the risk - if the underlying investments of the pension fund do not perform as expected, the money may not be there to provide the pension income that the scheme has guaranteed to pay to it's members, the scheme will therefore be operating at a loss and it will be the company's liability to cover that loss. In addition, with increasing life expectancy, schemes are having to pay out the guaranteed pension income for longer, again, costing them more than they may have anticipated.

I’ll now explain how a Defined Contribution (Money Purchase) pension differs to a Final Salary (Defined Benefit).

Within a Defined Contribution pension, regular contributions into the pension buy units in a fund or funds, depending on how your pension is invested (it’s important to receive advice to ensure the investment of your pension fund is suitable for your circumstances and tolerance of risk). The value of your pension ‘pot’ will then grow in line with the increase in the price of those units (it’s important to note that the value can go down as well as up) and with additional contributions as they are paid in. The pension income you receive in retirement is entirely dependent upon the value of your ‘pot’. Therefore, the amount paid in and the investment performance of the funds in which you invest will determine whether you can afford to retire in style.

It's therefore important to regularly review your pensions to ensure you are on track towards achieving the lifestyle you desire in retirement. Not many of us will want to rely solely upon the State Pension, and with the State Pension age regularly reviewed, it's likely that you won't receive this until at least age 67, or even 68 (for those born after 6th April 1978).

Increased pension flexibility allows people to draw from their private pension arrangements from age 55 currently (set to increase to age 57). There are options available in respect of how you use your pension fund to provide you with an income, and you can even draw ad-hoc lump sums, if this suits you better. Receiving financial advice in respect of your options is a good idea, to ensure you achieve tax efficiency and meet your objectives.

If you'd like to discuss any aspect of your retirement planning, whether it be reviewing an old pension scheme that you're no longer contributing to, setting up a new arrangement or reviewing your options for retirement, please do not hesitate to contact me for a consultation.

Charlotte Owen