It isn't hard to get confused and lost when looking at your pensions and the various options you now have following the new 'Pension Freedoms' legislation. Pensions have changed immeasurbly over the last 25-50 years and they are now more flexible than ever.
Pensions provided by employers can normally (but not always) be categorised as being either Defined Contribution, also known as Money Purchase or Defined Benefit, also known as Final Salary. They are what they say on the tin. Defined Contribution or Money Purchase pensions are built up from employer and employee contributions which is invested and the pension provided will depend on the level of contributions as well as the underlying performance of the investment.
Whereas Defined Benefit or Final Salary pensions provide a specific, pre-agreed benefit that is paid out and the pension provided will depend on a number of factors including but not limited to how long you have worked with the employer and your pensionable salary in the final year of employment.
The new 'Pension Freedoms' don't apply to Defined Benefit pensions and this has led to many people seeking financial advice on transferring their Defined Benefit pensions into a Defined Contributioni arrangement. It is a legal requirement to take financial advice where your transfer value is over £30,000 because of the valuable guaranteed benefits that are provided with these schemes.
So that you can better understand the differences between the two types of scheme and what they do for you, we have put together the following table. There are of course other types of scheme and not every scheme works in the same way.
Defined Contribution Pension / Money Purchase Pension
Defined Benefit Pension / Final Salary Pension
Provides an income set by the member based on how much they need. It could be more or less than that offered by a defined benefit scheme. The level of income can be increased or decreased at any time to take account of a change in circumstances. However, there is a possibility the fund could run out if the withdrawals taken are unsustainable, or investment performance is poor.
The pension income is a set amount, guaranteed for life, which will usually increase automatically each year to protect against inflation. There is no investment risk for the pension member and the pension scheme has to pay the member’s pension regardless of how well the scheme assets perform.
Income is payable for as long as there is money in the pension. It’s dependent upon the investment returns within the pension and whether withdrawals are sustainable. If you take too much out at an unsustainable rate, or live longer than expected, the fund may run out. Upon death any remaining fund can be passed on free of tax before age 75. It can be passed on at the beneficiary’s marginal rate of income tax after the age of 75.
The pension is payable for life and upon death is usually payable at a reduced rate to a partner or dependent -typically 50% - and payable for their lifetime. These payments are made regardless of how long you or your dependent lives. Once you and your dependents have died no further benefits are payable.
If you are in poor health, it may mean you have capacity to take bigger withdrawals before death, or you could instead use the fund to secure an alternative guaranteed income by purchasing something called an annuity. An annuity will ensure a guaranteed income for life and if you are in poor health, or have no dependents, it may mean you receive a higher income.
If you are in poor health, it does not alter the level of income the scheme will pay however, should you suffer a serious illness prior to the pension commencing, some schemes do pay benefits on different terms.
This could include paying the pension earlier and increasing the lump sum that varies with each scheme.
Tax Free Cash
In most defined benefit schemes, the member has the option of giving up some of the income and taking it as tax free cash (known as a pension commencement lump sum). This must be taken in one go.
Tax free cash is normally 25% of the total amount being taken out of the pension and can be taken in stages, rather than in one go.
The scheme normal retirement date is set by the scheme rules and a full pension is payable at that date.
Accessing benefits early, from age 55, is usually permitted subject to reductions reflecting the pension being payable for a longer period.
Benefits can be turned on and off from age 55 onwards but early access may impact the amount of funds available later in retirement. You can choose to secure some income at any time.
Employer Covenants and Finnancial Protection
There is no ‘employer covenant’ once you have transferred your defined pension scheme. Your pension is reliant on the underlying investments and how well they perform.
The Financial Services Compensation Scheme provides 100% protection in some cases should a pension provider fail.
The sponsoring employer of a defined benefit pension is bound by law to adequately fund a defined benefit pension. They can’t walk away from their pension liabilities should a scheme be underfunded, unless they go into liquidation. In the event of an employer going into liquidation, an underfunded pension scheme would have a call against any assets remaining upon wind-up, prior to any shareholders receiving any money.
Should a pension scheme not be able to meet its liabilities with no solvent sponsoring employer, the Pension Protection Fund is available to protect members of the scheme.
On top of the initial charges there will be product and investment management charges which will reduce the size of your pension fund. There are also likely to be ongoing advice charges. Typically, both are paid for from the pension fund but in times of poor investment performance these can have a greater negative impact on how long your money lasts.
The scheme is responsible for all the charges associated with running it. Unless you seek advice you will have no charges to pay.
Investment Risk and Performance
You bear the risk of the investment decisions taken in respect of the fund. Poor returns in the early years of retirement and taking money out at the same time can seriously affect the amount of income you could withdraw over the long term.
The responsibility for investment decisions and their consequences reside with the scheme trustees and their investment adviser/managers. The scheme pays for advice and administration and these do not affect your income.
Your investment choices will determine how much inflation protection you have. Lower risk assets may not provide enough return in the long-run to mitigate the effects of inflation.
The scheme will usually provide a rising income to protect against some of the effects of higher inflation.
When planning for your retirement you should always seek professional advice to make the most out of your benefits. Transferring out a defined benefit pension scheme is unlikely to be in the best interests of most people.