What is the main difference between a defined benefit (DB) and defined contribution (DC) scheme?
A defined benefit pension scheme provides a pension linked to a member’s salary and years of service with the providing employer, regardless of the ups and downs of financial markets or the contribution they have made in to the scheme over the years.
This gives defined benefit schemes a notable advantage over defined contribution pension, where your income will vary according to how much your pension investments are worth by the time you retire.
Your Guaranteed Benefits
Your defined benefit pension scheme will usually offer you a tax-free lump sum, plus a guaranteed income for life. Sticking with what’s already on offer to you has a number of advantages.
- You will get paid guaranteed income every month for the rest of your life: your pension payments are taxed as appropriate automatically before you receive them and you don’t have to worry whether markets are up or down, whether you live to 75 or 105.
- You may get other valuable bells and whistles: that can include a pension for your spouse on your death, discounts, memberships, and inflation-linking of your pension so that it keeps pace with rising prices over the years.
- You also don’t have to worry about how or where your money is invested: that is the responsibility of those who manage the defined benefit pension scheme (the trustees).
- You are protected by the Pension Protection Fund: as already noted, this was set up to pay compensation to members of defined benefit pension schemes should the sponsoring employer suffer an insolvency event. You can find out more about it at www.ppf.co.uk.
There is no temptation to dip into your pension investments: for example, every time you fancy a holiday, or the house needs refurbishment!
Transferring From A Defined Benefit Pension Scheme
It is usually possible to transfer out of a defined benefit pension scheme and invest the money through an alternative pension arrangement instead. If you are interested in the idea of this, your defined benefit pension scheme will give you something called a cash equivalent transfer value, which is an amount of money they offer you in return for giving up your rights to your guaranteed benefits under the scheme. In some cases, this transfer value can look very high and tempting because:
- We are in a low interest environment, this means the amount of money you need to generate an income equivalent to your guaranteed benefit under the scheme has grown compared to when interest rates were higher. This is factored into your transfer value. Interest rates may go up again in future which could reduce the transfer value you are offered compared to now. Interest rates may also go down in future which could increase the transfer value you are offered compared to now.
- In some cases, companies with defined benefit schemes are trying to reduce their pension liabilities and are therefore boosting transfer values.
However, you need to remember that you will usually still need to generate an income to support you in retirement and you may need a large amount invested in an alternative pension arrangement to do this. If you move to an alternative arrangement you will also be exposed to investment markets which can go down as well as up. You risk ending up worse off than had you kept your guaranteed benefits.
This is why it is so important – in fact compulsory if your cash equivalent transfer value is worth £30,000 or more – to take professional, specialised advice on whether a defined benefit pension scheme transfer is right for you, from an appropriately qualified and authorised adviser like Pensionhelp.
Most people will be better off staying in any defined benefit pension scheme they are a member of, and that is always our starting point at Pensionhelp. But – as we already touched on at the start of this guide – there are some valid reasons why you might consider it, and it is cases where these might be a factor that we usually focus on. In this guide we will cover reasons why a transfer may be suitable or unsuitable, depending upon individual circumstances.
- Flexibility on when you take your benefits: each defined benefit pension scheme sets its own retirement age and may not allow you to take early retirement.
- Flexibility on how to take your tax-free lump sum: in general, all pensions allow you to take a tax-free lump sum of up to 25% of the value of your pension benefits or investments on retirement. With a defined benefit pension scheme, you may be forced to take the tax-free lump sum in full the moment you want to take benefits from the scheme. An alternative pension arrangement would usually allow you to take this lump sum bit by bit, which may have tax advantages in certain circumstances.
- Flexibility on the level of income you can take: you can’t vary the income you receive from a defined benefit pension scheme over the years, to meet shifting spending needs or manage your tax liabilities for example. Moving to an alternative pension arrangement usually gives you options around this, using something called drawdown, which we’ll come back to later.
- The potential to buy a higher guaranteed income for life: for example, your defined benefit pension scheme may factor in a pension for your spouse after you die. If you don’t have a spouse, that means your pension will potentially be lower than it could be if you took the cash equivalent transfer value and asked an adviser to shop around elsewhere for a guaranteed income for life for you. The same goes if you have a health condition, where you may be able to buy a higher guaranteed income for life elsewhere if the provider doesn’t expect you to live as long as others.
- Control over who receives your death benefits: defined benefit pension schemes often give you no control over the death benefits they offer, which are paid in line with the scheme rules (usually in the form of a dependent’s pension that dies with them) and may be limited to spouses and children. In a defined contribution scheme, you can nominate whoever you like to receive whatever is left in your pension when you die – from grandchildren to the local cat charity.
Can you take a mix of guaranteed benefits and a cash equivalent transfer value from a defined benefit pension scheme?
Taking a mix of both may seem like the perfect option. You get a guaranteed income to pay bills, while retaining some flexibility by investing the cash equivalent transfer value part in an alternative pension arrangement. Unfortunately, many defined benefit pension schemes do not allow partial transfers. Usually to achieve this balance of guaranteed income and flexibility, you will need to transfer in full, and then look at a blended or hybrid approach (see below).
If you do decide to transfer money out of a defined benefit pension scheme to an alternative pension arrangement, you will then have to decide what to do with it to support yourself in retirement. Our advice will include recommendations for this if we do think transferring out of a defined benefit pension scheme might be in your interests.
The rest of this guide outlines the main options you can consider.