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Holborn Retirement Planning: Defined Vs Contributed Pensions

28th September 2016

Holborn Assets Retirement Planning - group of retired people sitting in sofa and using tablet

There are two main types of workplace pension:

  • Defined Benefit (DB) schemes. These are also known as Final Salary schemes.
  • Defined Contribution (DS) schemes. These are also known as Money Purchase schemes.

Workplace pensions run in conjunction with any private and/or state pension you may have.

Defined Benefits (DB) schemes offer the benefit of a guaranteed income for the rest of your life but no choice on how your pension is invested. Defined Contribution (DC) schemes offer no guaranteed pay-out but more flexibility, and are cheaper for employers to run than DB schemes.

DB schemes have effectively been phased out and replaced by DC schemes.

Many Defined Benefit schemes are still running, but you can’t get on one any more; not since 2012, when auto-enrolment began for Defined Contribution pensions. If you’ve signed up somewhere to work since, you will have been automatically enrolled onto a Defined Contribution pension scheme.

Here’s a summary of each of the two major types of workplace pension scheme works:

SCHEME FEATUREDEFINED
BENEFIT SCHEME(also known as
FINAL SALARY)
DEFINED
CONTRIBUTION SCHEME(also known as
MONEY PURCHASE)
ADVANTAGEEmployer takes the risk

The employer is responsible for providing the guaranteed pension sum (your “Pension Pot”) and also for making the investment choices.

 

Guaranteed Sum
You’ll know for certain what you’re getting in advance, and a monthly sum will be paid for the rest of your life.

 

Protected

Most employees with Defined Benefit schemes are protected by the UK Pension Protection Fund: “the PPF was set up in April 2005 to protect you if your employer goes bust and its pension scheme can no longer afford to pay your promised pension.” (PPF)

Five categories of compensation apply.

100% compensation will be paid if you were already retired when your scheme went bust. 90% compensation will be paid if you retired early, or had yet to retire when your scheme went bust. Deferral, caps and annual price rises apply variously.

The PPF has this year changed its insolvency modelling from Dun and Bradstreet to Experian.

Cheaper to run for employers

Contribution-based schemes are cheaper for employers to run.

 

Defined benefit schemes involve high administration costs in assessing individual pay-outs. A further drain on cost for pension chiefs of benefit schemes is that people are generally living longer, which makes it more expensive to pay employees for a lifetime.

 

Employee chooses investments

Some choice is available to employees of where their pension is invested. A good thing or a bad thing? Depends on how you look at it.

ANNUAL PRICE INCREASE?Index-linked
DB schemes enjoy a compulsory increase each year.How much your DB pension goes up each year depends on what money was put down by you when:§ For money laid down after 6 April 1997, there is an annual increase of 5%, or of CPI — whichever is lower.

  • CPI stands for “Consumer Prices Index” which is similar to the RPI “Retail Prices Index” but excludes mortgage interest).
  • For money laid down after 6 April 2005, there is an annual increase of 2.5%, or of CPI — whichever is lower.
Index-linked
As with Defined Benefit schemes, DC schemes enjoy a mandatory hike in value each year.How much your DC pension goes up each year depends on what money was put down by you when.It is important to note that:”There is no legal requirement for increases to be paid on:

  • Income coming from your pot from savings built up before 6 April 1997, unless you were contracted out; and
  • Income coming into payment after 6 April 2005.”
    (Pension Advisory Service, 2016)

Otherwise, the situation is similar to that for DB schemes in that an annual price hike in line with CPI/ alternative fixed rate applies to different bands of your pension pot depending on when it was invested. In the case of DC scheme annual price hikes, what is also taken into account is whether the scheme is trust or contract-managed.

WHO DECIDES WHERE THE MONEY IS INVESTED?The employer (or rather the pension professionals advising the employer). All contributions are invested as part of a collective pool.With some schemes, the employee is given some choice as to where to invest the money. Often there is a default fund which employees can opt for if they are not adventurous.
ENTITLEMENT SUM PAID
HOW?
The employee can take 25% tax-free of total entitlement as a lump sum.

A fixed sum is then paid for life every month.

As with DB schemes, the employee can take 25% tax-free of total entitlement as a lump sum.

With a DS scheme, you can take 100% of the pot in one go,or a proportion, in which case a decision then needs to be made about the rest of your pension pot:

A common choice is to buy an annuity which converts into a lifelong fixed income. Buying an annuity was compulsory until 6 April 2015.

Or you can opt for income drawdown. With this option, the asset base of your pension pot (i.e. the stocks and shares investments) is left on the stock market and you draw down an on-going income from it.

CALCULATION OF YOUR ENTITLEMENTThe calculation of your pension pot sum usually depends on three factors:

  1. The number of years you have paid into the scheme.
  2. Your salary (either final or career average).
  3. The “accrual rate” used by your provider. This is usually either 1/60th or 1/80th multiplied by your years of scheme membership.
The calculation of your pension pot sum usually depends on five factors:

  1. Your monthly contribution.
  2. Your employer’s contribution.
  3. How long you have contributed for.
  4. How well the underlying investments have done.
  5. Minus any fees and costs.
EARLY RETIREMENT?Can be taken aged 55+.Can be taken aged 55+.
WHAT TYPES OF SCHEME EXIST?Defined Benefit schemes are divided by how they use your salary to calculate your entitlement: “Final Salary” vs. “Career-Average Revalued Earnings.” (CARE).

  • “Final Salary” makes a calculation on your salary at the time of retirement.
  • “Career Average” schemes look at each year of your earnings separately and tops them up together in a wider calculation involving an index-linked revaluation for each year’s sum.

http://www.thisismoney.co.uk says: “Career-average schemes tend to favour workers who don’t have much career growth and who don’t get very high annual salary increases.” People whose salary goes up fast miss out, because the annual price-hike calculation may not be as high as their own rise in salary.

Defined Contribution schemes are divided by who looks after the money: “Trust-based” vs. “Contract-based”:

  • Trust-based means your employer has a Trust whose trustees are legally-obliged to protect and manage your investments.
  • Contract-based means your employer has a contract with a pensions provider, which usually means that the choice of investment is wider than with a Trust-based scheme.
WHO MAKES THE CONTRIBUTIONS?An agreed percentage is taken out of your salary before you are paid. Your employer makes a contribution, and the Government gives you tax relief on your contribution.An agreed percentage is taken out of your salary before you are paid. You can adjust this percentage as you go. Your employer makes a contribution, and the Government gives you tax relief on your contribution.
NEWSIn March 2016 the Pensions and Lifetimes Savings Association launched the DB Taskforce with a mandate to review the challenges currently facing DB pension schemes and report to the Government.No such taskforce is envisaged for DC pensions. But the rule change of April 2015 that widened the way employees can access their Pension Pot continues to be influencing the market.

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At Holborn Assets Retirement Planning we offer both defined and contributed pensions. Our strong team of independent financial advisors are ready to guide you in your journey to financial freedom through thick and thin. Suffice it to say, if you’re interested in retirement planning Holborn Assets is the best place to start. Get in touch with us today!

 

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