A defined benefit pension is one which promises a pre-defined level of benefit at retirement (such as 50% of final salary), payable until death. The benefit is defined and contributions to the pension are not defined. All of the risk involved in this type of scheme is borne by the employer. The alternative to a defined benefit pension is a defined contribution pension, where the level of contributions is defined and the benefit at retirement is whatever can be made available based on the contributions, plus growth, less charges. All of the risk in this type of pension is borne by the employee.
In the last ten years, many defined benefit schemes have been wound up or had benefits reduced. If you have a defined benefit pension it may well be worth your while considering all your options.
There are five main reasons why so many defined benefit pension schemes are in deficit;
- longer life expectancies which increases future liabilities
- lower annuity rates
- lower discount rates (due to lower interest rates) which mean that the present value of future liabilities is higher
- lower investment returns, and
- reduced commitment from employers
Many people who have a defined benefit pension give serious consideration to taking a transfer value out of the scheme, especially those who are close to retirement age. We examine below some of the factors which can impinge on the decision whether to remain in the scheme, or take a transfer value.
If you get to retirement age and take your benefits without your scheme being wound up or restructured, you may (if the scheme purchases an annuity for you) be clear of any danger. If the scheme pays your retirement income directly however, at least some of your pension income may still be at risk if the scheme were to become insolvent, even after your retirement date. There are a lot of other factors which might influence a person in this situation, some of which might be as follows (this list is not exhaustive);
- It used to be considered that a defined benefit pension was guaranteed to be paid; this is no longer the case. A defined benefit pension is a promise (not a legal obligation) and whether the scheme will be able to make good on it is another matter.
- Where a defined benefit scheme is in deficit and it appears that the employer is not motivated to rectify the situation, transferring to a defined contribution scheme at least makes it possible that you will maintain the value of your pension.
- If a defined benefit scheme is wound up with a deficit, deferred members are likely to get a transfer value which is adjusted downwards because of the insolvency of the scheme. Do you expect the scheme’s funding position to deteriorate further and if so should you get out now?
- As a member of a defined benefit scheme if you die shortly after your retirement your defined benefit pension dies with you (save for any guaranteed period or widows/dependants pension). If you want to preserve the value of your pension to pass on to your dependants you need the ARF option which you could get in a defined contribution scheme.
- When you transfer from a defined benefit scheme to a defined contribution scheme you take over the investment risk which previously sat with the trustees of the scheme.
- Having a defined benefit pension (provided it stays solvent) eliminates longevity risk (the risk of you living long enough to expend your pension pot).
- In general the transfer values which are made available to those leaving defined benefit schemes have increased in recent years, as a result of lower long term government bond yields, however the recent increase in inflation and bond yields may result in a reversal of this trend.
It is important that you obtain advice on this issue from a suitably qualified adviser. If you find the above confusing don’t worry, we can explain it and the other relevant issues to you in simple terms.
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© Eoghan Gavigan 13 November 2021