Helping you understand your pension

Following changes to legislation, known as ‘Pension Freedoms’, you now have more flexibility in the way you can access your pension funds, although this will not necessarily be through your existing scheme.

Transferring out of a defined benefit pension scheme is unlikely to be in the best interests of most people.

You should consider the following carefully before you choose to proceed with requested advice.

The following compares some of the features of a defined benefit pension scheme compared to a defined contribution scheme.

INCOME

Defined Benefit:

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

Defined Contribution:

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 benefits 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 are unsustainable, (ie are too large to be maintained), and/or investment performance is poor. A guaranteed income could be purchased at any time with some or all of the remaining money.

DEATH BENEFITS

Defined Benefit:

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

Defined Contribution:

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 but will be taxed at the beneficiary’s marginal rate of income tax.

POOR HEALTH

Defined Benefit:

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.

Defined Contribution:

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. A typical 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 than your defined benefit scheme is offering.

TAX FREE CASH

Defined Benefit:

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.

Defined Contribution:

Tax free cash (known as a Pension Commencement Lump Sum or PCLS) is normally 25% of the total amount being taken out of the pension and can be taken in stages, or all in one go.

RETIREMENT DATE

Defined Benefit:

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. In some cases, there is an earlier protected retirement age, for example age 50.

Defined Contribution:

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 by buying an annuity to provide a lifetime or short term guaranteed income at the rates available at the time.

EMPLOYER COVENANTS AND FINANCIAL PROTECTION

Defined Benefit:

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.

Defined Contribution:

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.

CHARGES

Defined Benefit:

The scheme is responsible for all the charges associated with running it. The scheme may work closely with a firm of financial advisers and any advice would typically be chargeable.

Defined Contribution:

There will be product, investment management, and possibly platform charges which will reduce the size of your pension fund. After the initial advice fees, there are also likely to be ongoing advice fees. Typically, these are paid out of the pension fund but in times of poor investment performance these can have a bigger impact on your pension, which means it could run out sooner than planned.

INVESTMENT RISK AND PERFORMANCE

Defined Benefit:

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.

Defined Contribution:

You bear the risk of the investment decisions taken and throughout the time the funds remain invested into your later years. 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.

INFLATION PROTECTION

Defined Benefit:

The scheme will usually provide a rising income to protect against some of the effects of higher inflation.

Defined Contribution:

Your investment choices will determine how much inflation protection you have. Lower risk assets may not provide enough return in the long run. Higher risk assets whilst potentially offering greater inflation protection, may suffer more losses reducing their overall returns. In short, investment returns will always be uncertain.