Defined Benefit Pension Schemes Explained

Introduction

Fewer people are members of Defined Benefit schemes these days although many people approaching retirement might have deferred benefits from earlier in their careers.

I thought I would share with you an overview of how Defined Benefit schemes work and why they are so attractive. I will also look at how benefits might be included in a client’s overall financial planning strategy.

What is a Defined Benefit Scheme?

A Defined Benefit scheme is an occupational pension scheme where your benefits are determined by:

The scheme’s accrual rate.
The number of years you were a member of the scheme.
Your salary when you left the scheme or at the date of retirement.

These types of schemes are generally only offered by large employers albeit many companies have closed their Defined Benefit schemes to new members over the years due to the rising costs of providing benefits to members.

Defined Benefit schemes are also found in the public sector.

Funded and Unfunded Defined Benefit Schemes

Generally speaking most private sector Defined Benefit schemes will be funded whereby the employer and employee contributions are invested in a large pension fund designed to pay benefits to the members and deferred members of that scheme.

An actuary will calculate the funding levels required and the investment risk is borne by the employer. As more and more Defined Benefit schemes have closed so employers and trustees have sought to match their investment risk with their liabilities and hence we have seen pension funds move away from assets such as Global Equities to Government Bonds.

Most public sector schemes, for example, The Teachers Pension Scheme, the NHS Superannuation Scheme and the Civil Service Pension Scheme among others are unfunded meaning that there is no underlying fund and benefits are provided by way of general taxation.

How do you Calculate Pension Benefits?

Benefits under a Defined Benefit Scheme are calculated as follows:

Accrual rate x length of service x final salary.

As an example, Dave is retiring after 40 years’ service in a scheme with an accrual rate of 1/80ths and with a final salary of £30,000.

His pension can be calculated as 1/80 x 40 x £30,000 = £15,000.

Different schemes can have different accrual rates with 1/60ths being relatively common in the private sector and 1/80ths being typical in the public sector. Some schemes may have a particularly generous accrual rate of 1/40ths.

When benefits become payable, they will continue for the rest of your life and will go up broadly in line with inflation.

Definition of Salary

This is where things get slightly more complicated.

Firstly, the scheme will have a definition of what it means by pensionable salary. For example, it might be basic salary plus overtime or it might be basic salary with or without a bonus.

Secondly, more and more schemes are moving across from final salary to career average salary.

Using final salary was a way of rewarding those members who had been with their employer for a long time and was usually calculated as the average of the last three years pensionable earnings. There could be variations on this but the premise was that your highest salary would be towards the end of your career and your pension benefits would be based on this amount.

As a way of reducing costs, a number of schemes use career average earnings. This is where an average is used across your membership of the scheme which is revalued in line with inflation. Your benefits are worked out by adding together the pension earned for each year of membership.

Where schemes have introduced this, and many public sector schemes have, you may end up having some benefits under a final salary scheme and some benefits under a career average earnings scheme.

Tax Free Cash

As well as pension income, Defined Benefit schemes will provide tax free cash and this can be calculated in a variety of different ways and can get rather complex.

Some schemes will provide tax free cash in addition to pension, for example, you may receive a tax free lump sum of three times your pension in addition to your pension income.

For most schemes, however, if you take a tax free lump sum, you will need to take a reduced pension. The amount that your pension is reduced by is known as a Commutation Factor.

Normal Retirement Age (NRA)

All schemes will have a Normal Retirement Age which is the age at which you can start to take benefits without any actuarial reduction.

For many schemes, particularly in the private sector, the Normal Retirement Age will be age 60 or 65. For many public sector schemes, the Normal Retirement Age is linked to the State Pension Age which could be age 66 or 67.

Although benefits from pensions can be taken from age 55, you will usually face a reduction in the level of your pension if you take benefits before the Normal Retirement Age. This is calculated by the actuary and can vary from scheme to scheme. However, 4% for each year before Normal Retirement Age is not uncommon.

You don’t normally have to retire in order to take benefits from the scheme but you should speak with your employer or the scheme Trustees to ensure that this is possible.

What Happens If I Leave The Scheme?

If you leave the scheme before the Normal Retirement Age, your benefits are calculated based on the scheme’s accrual rate, your length of service and your salary (or career average salary) at the date you left. It is then re-valued, usually with a link to inflation, until Normal Retirement Age or the date you take benefits.

Death Benefits

When you die, the Defined Benefit scheme will pay a pension to your spouse or partner and this is usually a percentage of your pension.

For many schemes, the percentage is 50% of your pension although there are schemes that pay a two-thirds pension. Depending on the scheme rules, your spouse may receive a percentage of your actual pension or the full pension you were entitled to had you not taken the tax free lump sum.

Some schemes will also pay a pension to dependent children whilst they are in full-time education.

Many schemes will also provide a five year guarantee which will provide a lump sum if death occurs within a five year period after retiring. The lump sum will be the value of the remaining income payments during that period.

What Happens If My Employer Goes Bust?

If your employer goes into liquidation then the scheme will enter the Pension Protection Fund (PPF) which is a government-backed scheme designed to prevent people losing all of their pension benefits. However, not all pension benefits will be covered.

Those in retirement should receive 100% of their pension benefits.
Those not in retirement should receive 90% of their pension benefits.

Why Are Defined Benefit Schemes So Good?

There are a number of reasons why Defined Benefit schemes are so good and why they are known as ‘gold-plated’ pensions and this all comes down to the fact that benefits are more or less guaranteed. In other words, it is the employer who bears all of the investment risk to provide the benefits and not the member.

If we contrast this with a Defined Contribution or Personal Pension Plan, the individual bears all of the investment risk and is responsible for where the pension fund is invested. When benefits are taken, it is the individual who is responsible for what options are chosen and how the underlying fund is managed to provide an income in retirement.

Most people with benefits in a Defined Benefit scheme significantly under-estimate the value of their benefits.

As an example let’s look at the case of Bert and Ernie.

Bert and Ernie

Bert is a member of his employer’s Defined Benefit (Final Salary) scheme and he is coming up to retirement at age 60 after completing forty years’ service. The accrual rate is 1/60ths and Bert’s final salary is £45,000. The scheme offers a 50% spouse’s pension.

Assuming that Bert takes his full pension (let’s ignore tax free cash for now), he will receive a pension of £30,000 per annum increasing in line with inflation.

Ernie also earns £45,000 but is a member of his employer’s Workplace Pension where he pays in a percentage of his salary and his employer matches it. Ernie has to choose where to invest the contributions and chooses a ‘Balanced’ investment fund.

Ernie wants the same guarantees as Bert and so wants to purchase an annuity at age 60 that pays him £30,000 per annum increasing in line with inflation and with a 50% spouse’s pension.

Using current annuity rates, Ernie is shocked to discover that he needs a pension fund of around £869,562 to buy an annuity equivalent to the benefits that Bert will receive.

Financial Planning and Defined Benefit Schemes

Given that pension income from a Defined Benefit scheme is guaranteed and will largely increase in line with inflation, the benefits can play a vital part in a client’s financial planning strategy.

Kermit’s Financial Planning Strategy

Let’s look at Kermit’s situation. He has deferred benefits under a Defined Benefit pension scheme of around £20,000 per annum from age 60 plus various other personal pensions. He also has full entitlement to the Basic State Pension. Kermit would like to retire at age 60.

After discussing with Kermit his ideal lifestyle in retirement and analysing his likely expenditure, we were able to determine that his core expenditure in retirement was broadly £20,000 a year. This included expenditure items such as general household expenditure, utility bills and running his car.

Kermit then had various leisure and luxury expenditure items such as meals out, hobbies as well as weekends away.

Kermit also wanted to replace his car, upgrade the kitchen and spend a few weeks on the beach in the Caribbean.

We allocated Kermit’s Defined Benefit pension scheme to paying his core expenditure. This gave him the peace of mind that, no matter what, he could meet his basic living costs for the rest of his life.

We then consolidated his various other pensions into a single SIPP wrapper and took 25% of the pension fund by way of tax free cash to pay for the replacement car, upgrade to the kitchen and the Caribbean holiday.

We then used the remaining 75% pension fund to provide an income to pay for Kermit’s leisure and luxury expenditure items. During the early and most active phase of retirement, Kermit was happy to drawdown a relatively large amount of income as this was the time he wanted to make memories for later life.

At age 67, Kermit’s State Pension kicked him giving him another inflation-linked source of income which also meant we could scale back the income being withdrawn from his SIPP.

By taking into account Kermit’s deferred benefits under his Defined Benefit scheme, his various personal pensions and his State Pension we were able to show that he could live his ideal lifestyle in retirement and not run out of money.

Conclusion

Defined Benefit schemes provide valuable pension benefits that most people greatly under-appreciate. They are pretty much secure and will increase broadly in line with inflation and, to provide similar benefits by way of an annuity, will require an extremely large pension fund.