Although defined benefit pensions are somewhat of a rarity these days, many people in their forties or fifties have DB pensions from previous employment.
In this article, we explore the differences between defined benefit pensions and defined contribution pensions, pension freedoms and how to get a clear idea of what your pension is worth.
What is a Defined Benefit pension?
DB pensions, sometimes called Final Salary pensions, are pensions that pay a pre-determined amount to you depending on a factor during your employment, usually your final salary before you leave, or sometimes your average salary while you were employed.
When you join a scheme like this, the company takes some money from your salary, and usually contributes some money themselves each month. This money is invested by the company pension scheme to produce returns, from which your pension will be paid when you retire.
The company pension scheme guarantees to pay you the agreed amount from your retirement until you die. When you die, there is no residual amount left to pass to heirs.
The pension scheme has to ensure it has enough money to fund everybody’s pension, and it does advanced calculations based in investment returns and longevity of scheme members to ensure it can provide the pension payments.
What is a defined contribution pension?
So if your pension is not defined benefit, what is it?
The other type of pension is called defined contribution. This means simply that you and your employer contribute a fixed amount each month to a pot of money, which the Government lets you do before taking off income tax.
This money is invested by your pension fund manager and you get to draw down the money in regular instalments when you retire.
The Government passed legislation in April 2015 giving individuals more choice in how they want to manage their pensions.
Following retirement, it became legal to withdraw up to 25% of your accumulated pension pot tax-free.
Can you exchange a DB pension for a DC pension or vice versa?
Yes, in a way.
The firms who run DB pension funds are often willing to give a cash equivalent transfer value to members in exchange for their ongoing pension rights.
Because of the low rates of return on invested funds, sometimes these CETVs can be high multiples of the annual amount you are entitled to collect.
Tideway has a handy CETV calculator which can help you understand the range of offers you could get for a DB pension.
The benefit on transferring your DB pension into a cash amount is that you gain complete control over how it is invested, and if you don’t spend it all, you can pass it on to future generations.
The disadvantage of transferring your DB pension is that you are giving up valuable guaranteed benefits from the date you retire until you die.
Because of the complexity surrounding pensions, the legislation requires that you take professional advice before transferring out of a guaranteed income scheme. In most cases it is more sensible to stay in the scheme, as the pension company is taking the risk of investing your funds for you, whereas if you transfer out, your investment strategy might not result in sufficient income to meet your needs.
Turning a DC scheme into a DB scheme.
This is essentially the same as buying an annuity.
An annuity is a promise from a pension fund that they will pay you a fixed real amount each year until you die.
This takes away any worry that you have about whether or not your pension investments will continue to perform for you.
You can buy an annuity by spending your DC pension fund with a company that provides annuities. In recent years, annuities have been very expensive, for the same reason that CETVs have been generous – namely that risk free investment returns have been low.
Understanding the value of your pension
The most accurate way to understand the value of your DB pension is to contact the pension administrator and ask them for a prediction of
- What your scheme is likely to pay when you retire (usually the scheme will give you this figure in today’s money, but the actual pound figure will rise with inflation)
- What transfer value they would offer for you to leave the scheme.
As always, pension discussions can quickly get complicated and if you need some advice to assist you with pension planning, or merely interpreting the documents you receive from your pension fund, don’t hesitate to reach out to a Tideway advisor who will be pleased to assist you.
- The content of this document is for information purposes only and should not be construed as financial advice
- Please be aware that the value of investments, and the income you may receive from them, cannot be guaranteed and may fall as well as rise
- We always recommend that you seek professional regulated financial advice before investing
