What you give up by transferring out of a defined benefit pension

The Pension Freedom and choice reforms have led to a surge in interest in transfers from defined benefit to defined contribution schemes to access those freedoms.

Outside of the public sector the option to join a defined benefit scheme is now very rare. However, there are of course many people in existing schemes either continuing to accrue benefits or with deferred benefits.

For many with accrued defined benefits, this will be one of their most valuable assets, however, due to their opaque nature, few will have an understanding of their true value.

WHAT ARE THEY?

Defined benefit schemes were the traditional form of employer pension scheme. Essentially, they are a promise to pay the member a pension for life, the level of which will be determined by an employee’s length of service and level of earnings. The amount was often based on the earnings at the end of employment, hence the name final salary.

Each scheme will have its own rules which will set out the basis of accrual and benefits.

A typical scheme would aim to offer a pension of 2/3rds of their final remuneration based on working for the same company for the whole of their working lives, usually assumed to be 40 years.

For example, they would accrue 1/60th of their final salary for each year of work. Therefore with 40 years of service this would accrue 40/60ths of their final salary ie 2/3rds.

The benefit for the member is therefore a level of certainty. The other key aspect and key benefit is that the initial pension payable will be indexed and paid out for the rest of the client’s life. With defined benefit schemes the employer takes all of the investment risk.

The definition of ‘final salary’ or final remuneration will also make a significant difference to the value of benefits with some schemes offering career averages and some basing it on the highest salary paid. Some will only be based on basic salary, others may include other benefits such as an average of recent bonuses.

There are also wide variations in the level of member contributions required.

This all means that whilst a defined benefit scheme can be an extremely valuable benefit there are huge variations in the value of these benefits for individuals. In addition, as the benefits are essentially a promise, members need to consider the scheme’s ability to be able to fulfil that promise, particularly with many schemes currently in deficit.

The ‘promise’ aspect and the certainty of benefits assuming the promise is kept, contrasts significantly with a defined contribution or money purchase scheme, where the individual member takes all the investment risk.

TAX FREE CASH

Under defined benefit schemes how tax free cash is calculated also differs considerably from defined contribution schemes. In most cases defined contribution tax free cash calculations are straightforward – it is simply 25% of the accumulated fund.

With defined benefit schemes the member’s tax free cash entitlement is calculated based on the scheme’s own rules, with most offering tax free cash by commutation. Commutation involves giving up an amount of accrued pension income in exchange for tax free cash.

DEATH BENEFITS

Death benefits under a defined benefit scheme are usually offered as a death in service lump sum payment and  a dependant’s scheme pension. The lump sum is usually expressed as a multiple of salary, typically four times salary but as with other benefits there will be wide variations from scheme to scheme. As the name implies this benefit is usually only payable while the member is still working.

The dependant’s scheme pension is only payable to a specific set of dependants. These will be limited by the legislative definition of dependants but the scheme’s rules will often have much narrower limits for example only making payments to a spouse or civil partner.

As with member’s pension benefits the level of dependant’s scheme pension will vary from scheme to scheme. A typical scheme may offer half the benefits that would have been payable to the member. More generous schemes may offer 2/3rds.

A dependant’s scheme pension will end on the death of the dependant at the latest but can sometimes end earlier than this, for example if the recipient remarries.

The inflexible nature of death benefits under a defined benefit scheme contrasts significantly with the new Pension Freedoms available to defined contribution schemes.

Defined contributions members can nominate anyone to receive benefits. The benefit will be equivalent to the full value of the accumulated fund and where benefits are kept in beneficiary’s drawdown any remaining benefit can be passed down through the generations. This flexibility means that defined contribution schemes provide the option to use pension funds as a useful estate planning tool.

REVIEWING BENEFITS

As I have highlighted above, not all defined benefit schemes are equal.  When reviewing the value, the starting point will always be to check exactly what benefits are provided.

The cash equivalent transfer value of the benefits will provide the current monetary value of benefits. However, this is only one aspect that needs to be considered. The importance to you of the certainty of benefits and the value of any beneficiary’s pension, and the giving up of this, will also be highly relevant.

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