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Following the introduction of Auto Enrolment in 2012, more and more people are accumulating savings through employer funded pensions which they can call upon at retirement to provide them with an income. This could be in addition to other pension savings they have accumulated, or from the state in the form of a State Pension.
We write extensively on the subject of pensions and this article explores arrangements where benefits have accumulated over a number of years' service through a final salary pension (also known as defined benefit (DB)) scheme.
Generally, DB schemes are considered to be more secure than their defined contribution (DC) counterparts a great deal of value is attributed to these types of arrangements, primarily because benefits are defined (hence the title) and the member bears none of the risks.
Considerably fewer DB schemes operate today compared with previous years and there is an increasing frequency of schemes being closed or being expected to close in the imminent future. Others are reported to be underfunded, causing concern over whether the schemes can continue to meet their ongoing liabilities.
What is a DB pension?
A DB arrangement provides safeguarded benefits for members, in the shape of a pre-determined, inflation-proofed income for life in retirement. It is calculated based upon a member’s earnings, the number of years pensionable service that a member has completed - usually defined as being both employed and an active member of the pension scheme – and an accrual rate. The accrual rate equates to a proportion of final salary for each year of pensionable service and the most common are 1/60th or 1/80th schemes. The majority of the costs in funding these schemes are borne by the employer.
The scheme rules agree to pay a defined income to a member of the scheme until they die. This income will not decrease in payment as there is likely to be a pre-determined level of escalation built in. Often there will be a spouse’s pension built in too, which will be a pre-determined proportion of the member’s entitlement – frequently 50%. This could be compared to the State Pension, which also escalates in payment.
Due to increasing longevity and reducing fixed interest yields, the costs associated with providing these pensions have become increasingly unpredictable and prohibitive. The combination of people living longer, long term low interest rates and fears over inflation have created a perfect storm for some DB pension scheme trustees.
What is worth noting is that there is simply no option for a member to alter the terms laid out by the scheme rules, which are administered and implemented by the scheme trustees.
Certainty v flexibility
If a member wants to define their own terms and payment levels and frequency, they will not achieve this through a DB arrangement. By the same token, if they transfer out of the scheme then they will lose the certainty that the arrangement provides. These schemes offer members a known payment in the future, right up until they die, whereas other (DC) pension scheme arrangements provide no such guarantees and could be merely seen as sacrificing certainty in exchange for choice and flexibility.
Some DB pension schemes have offered deferred members enhanced transfer values as an incentive for them to take their accrued pension elsewhere, but whilst some of these values have been very considerable, it should be remembered that all that glisters is not gold. By a scheme making this offer (and the member accepting it) the scheme trustees are discharging themselves of the future burden of funding an unknown (and spiralling) cost of paying a pension income for an indeterminate timeframe.
If you live to be 100 years old, the DB scheme would be guaranteeing to continue to pay you the pre-determined, escalating income laid out in the rules until the day you die. If you begin taking your pension at say age 65, then the DB scheme must continue to pay you for another 35 years. Plus, as each payment they make will increase every year, this means there is an ever increasing liability which the scheme needs to fund for.
If a member does decide to take a substantial transfer value to provide the choice and flexibility to do with as they wish, then they absorb all the risks, so this is why professional advice is always essential. Indeed, it is a mandatory requirement in the majority of cases, bearing in mind that the promise made by an employer’s scheme is being given up. The decision is almost always irrevocable too, which is why transfer away from DB schemes is usually regarded as unsuitable.
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