A defined benefit (DB) pension plan is a type of employment based pension that pays a retirement income based on the rate of accrual, the length of membership in the scheme and salary information—often based on the amount you are paid at the time you retire or leave the scheme. The employer contributes to the scheme, but depending on the plan, you may also have the option to contribute.
The defined benefit you receive from this type of pension scheme is guaranteed. You should receive your defined benefit amount throughout your entire retirement, and your pension benefit amount usually increases each year. There is usually a death benefit payable to a spouse, but not usually to a partner or other dependants. Death benefits under a defined benefit scheme are subject to the scheme’s specific rules. Keep in mind that defined benefit pension schemes have different rules for many of their features which can vary significantly from one scheme to another.
For most defined benefit pension schemes, the retirement age is 65. However, you may have the option to begin drawing pension benefits earlier at the cost of a reduced benefit amount. There are some situations—such as if you are in poor health—where you might be able to take out money early with minimal or no penalty at the Scheme trustees discretion.[i] However, if you are simply looking to retire early and take your benefit before the normal pension retirement age, you should consider whether your specific scheme allows early withdrawal and the drawbacks that may be associated with that option. Carefully evaluate if taking defined benefit pension payments early may reduce the amount you receive in retirement and how that would affect your income needs.
If you have access to an employer-provided pension scheme, you likely have either a defined benefit or defined contribution pension scheme. There are fundamental differences to each type of scheme, and the differences may affect your long-term retirement pension planning.
Unlike defined benefit schemes, defined contribution schemes are a type of pension where the eventual benefits are based mainly on the amount of money paid into the scheme over time and the growth of the underlying investments. Contributions to these pension schemes can be made by the employee, employer, or both. It is usually up to the employee to select the specific investments from the pension provider’s range of options, which may include equities, fixed interest securities, cash or other investment options. The value of a defined contribution pension is not usually guaranteed and may go up or down over time depending on the contributions made, what investments are chosen and how those investments perform. If you have a defined contribution plan, you may need to evaluate and select the appropriate investments for your needs.
For employees with defined benefit plans, the employer is responsible for ensuring there is enough money to meet the set pension income. The guaranteed benefit will not depend on you choosing assets or investment types, and as long as the Scheme is still solvent it is required to pay the promised benefit.
It may be possible to transfer your defined benefit pension to a defined contribution scheme, at the discretion of the trustees. Some people may consider transferring their defined benefit pension to access earlier benefits since defined contribution schemes often can be more flexible with earlier withdrawal limits. However, you should thoroughly assess the potential effects before making this change. Unless the value is low, a financial adviser is usually required to provide advice in this area, due to the high risk nature of the decisions involved.
Under the Parliament’s Pensions Act 2008, employers have a responsibility to ensure automatic enrolment of eligible employees into a workplace pension scheme unless the employee opts out. As a part of automatic enrolment, your workplace must also contribute a minimum amount dependent on the pension scheme’s rules and the government’s mandate. However, employees can opt-out of their employer’s benefit scheme, which means they may lose access to potential contributions from their employers.
When you are automatically enrolled in a workplace pension scheme, you will be informed and given information on the scheme itself, how it is run, contribution information and more. Reviewing this content is a good first step when planning how to use your pension scheme in the future.
There are a number of tax considerations to keep in mind when deciding how to take pension income. You normally receive tax relief when contributing to your pensions, but the benefits you receive in retirement are usually taxable. If your annual income (including any pension income) is more than your Personal Allowance, you will pay tax. If you are still working whilst drawing pension benefits, both your working income and pension benefit income count towards taxable income.
Most defined contribution pensions allow you to take up to 25% of your pension as a tax-free lump sum. Defined benefit pension schemes have specific rules on how much you can take as a tax-free lump sum, and there is no flexibility to draw varying tax free sums to meet your requirements. Apart from any available tax free lump sum available, withdrawals will be taxed as ordinary income in both cases.
When it comes to retirement planning, understanding how much your retirement will cost and how you will meet those costs is crucial. What are your goals for retirement? Will your retirement income sources be able to provide enough income to reach those goals? Carefully consider your planned income sources in retirement and how they fit into your overall retirement plan and goals. The guaranteed nature of the income provided can make a defined benefit pension a significant part of your retirement income planning.
To estimate your retirement income, you should include your defined benefit pension schemes, the government’s State Pension, any personal pensions and investments you might have and any additional sources of income you expect in retirement.
If you will receive pension income from a defined benefit scheme, your scheme should provide you with a benefit statement each year. This will be helpful when assessing if you are on track to meet your financial needs in preparation for retirement.
Understanding how your defined benefit pension scheme funds fit into your retirement plan can be difficult. A trusted pension adviser should be able to help you analyse your pensions and planned income sources to help you plan how you will meet your long-term financial goals.
Fisher Investments UK may be able to help with your retirement income planning. Contact us today to speak with one of our qualified professionals or download one of our educational investing guides to learn more.
[i] Gov.UK, as of 08/10/2018. https://www.gov.uk/early-retirement-pension/personal-and-workplace-pensions