Discover the different benefits of a defined benefit scheme when compared to a defined contribution scheme.
A typical final salary or defined benefit scheme will pay a pension that is linked to your earnings and the length of time you were employed. The income you receive is not linked to the amount you paid into the pension scheme or the investments held in the scheme.
This type of scheme generally provides a higher level of security with a set income being paid every month. There is usually an annual increase linked to inflation which provides further protection. This type of pension means you do not need to worry about investment performance and is similar to a regular wage.
Your Defined Benefit Scheme
Remaining in your scheme and taking benefits directly offers a host of advantages:
- You can exchange part of your pension for a lump sum. This lump sum is tax free and can be used to provide a degree of flexibility in your retirement alongside a secure income.
- There are other features which are usually attached to the pension: such as a survivor’s pension, a guarantee that it is paid for a minimum period (usually 5 years) and also a degree of inflation proofing.
- It can make your retirement stress free, you do not have to keep an eye on investments or worry about your pension fund running out.
- You receive a degree of protection from the Pension Protection Fund: if your former employer suffers an insolvency event. More details on this important protection can be found at www.ppf.co.uk.
Alternative Options to the Scheme Pension
If you wish to review alternatives to the scheme pension, you can usually obtain what is known as a cash equivalent transfer value. If this route is suitable for you this money can be invested into a Personal Pension. Accepting the transfer value and moving away from the scheme gives up all of your rights in the scheme and any decision to move out of the scheme is usually irreversible.
In some instances, the transfer value can look very tempting, but it is important to note that an inflation linked, regular pension can soon add up and it is easy to underestimate the real value of a regular income.
The decision to transfer out of a valuable pension is a complex one that will expose you to new risks and charges. Due to the significance of this decision, if your transfer value exceeds £30,000 then it is compulsory for you to take regulated financial advice before you transfer.
The starting point for defined benefit advice is that the transfer option is unsuitable. There are however some reasons why people may think that moving away from the scheme would be beneficial. The following factors are the reasons why people consider reviewing their options when they are members of defined benefit schemes.
However, you need to remember that you will usually still need to generate an income to support you in retirement and you may need a large amount invested in an alternative pension arrangement to do this. If you move to an alternative arrangement you will also be exposed to investment markets which can go down as well as up. You risk ending up worse off than had you kept your guaranteed benefits.
This is why it is so important – in fact compulsory if your cash equivalent transfer value is worth £30,000 or more – to take professional, specialised advice on whether a defined benefit pension scheme transfer is right for you, from an appropriately qualified and authorised adviser like Pensionhelp Direct.
Most people will be better off staying in any defined benefit pension scheme they are a member of, and that is always our starting point at Pensionhelp Direct. But – as we already touched on at the start of this guide – there are some valid reasons why you might consider it, and it is cases where these might be a factor that we usually focus on. In this guide we will cover reasons why a transfer may be suitable or unsuitable, depending upon individual circumstances.
Flexibility
The most common reason for people to review their defined benefit pension is ‘flexibility’. This means different things to different people, and for us to consider recommending transfer we need to establish what flexibility means. The areas below are the main reasons people cite where they are looking for an alternative structure to the scheme pension.
- Timing of benefits: The scheme sets its own retirement age. Transfer allows you to take benefits from age 55 (the minimum age will increase to 57). Most schemes do have early retirement options, but reductions to the scheme pension may make early retirement impossible which leads people to explore the alternative routes.
- Lump Sum Flexibility: Most defined benefit pensions allow a lump sum to be taken. This will be tax free and must be taken, with the income, at the outset. Transfer allows you to take the lump sum out in stages and can be taken without income. This gives a greater degree of tax control and can appeal to individuals, especially those who have a great deal of control over other sources of income.
- Income Flexibility: If you take the scheme pension you will receive the level of benefit calculated under scheme rules and this will increase over time. Some scheme members who review their pension do not want this ‘shape’ of income. They look to explore taking different levels of income according to need, such as taking higher income levels before state pension starts, or looking to reduce income as they approach the later stages of retirement.
What Happens When You Die?
Many scheme members review their options as they have concerns about what will happen to their pension when they die. Under the scheme rules, members very often do not have any control over what happens, typically a reduced pension is paid to a surviving partner. This is unattractive to certain individuals, so they look towards alternative options. People with a reduced life expectancy may also feel that the scheme rules would not pay death benefits in line with their wishes and that an alternative route may be more suited to them.
Alternative Secure Benefits
Moving away from a defined benefit scheme does not always mean a loss of a secure income. You can purchase a guaranteed income if you move away from the scheme. Many people who review a defined benefit pension do so to buy a different type of secure income which is more in line with their circumstances. This route is attractive to those with a reduced life expectancy or those without a spouse.
Blended solutions including part secure income and part investment
It is possible to use a ‘mix’ of solutions. This was a secure income can be taken to meet essential and regular expenditure and part of your benefits can remain invested and used for one off expenditure or used as a legacy. This can sometimes be done using the scheme to pay the income if they offer a partial transfer option, or through using a personal pension and an annuity plan. (see below)
If you do decide to transfer money out of a defined benefit pension scheme to an alternative pension arrangement, you will then have to decide what to do with it to support yourself in retirement. Our advice will include recommendations for this if we do think transferring out of a defined benefit pension scheme might be in your interests.
The rest of this guide outlines the main options you can consider.
