This week, the Government proposed changes to the way defined benefit pensions are calculated. In short, it means if you have benefits in a defined benefit scheme, you could find your pension income on retirement is lower than you expected. The reason behind the move is to make sure that defined benefit pensions are still sustainable, once people retire and start receiving their pension payments. We can’t grumble about that approach – it is a sensible course of action to take in the long-term, but it does mean that some people are likely to lose out and get less in retirement than they expected.
What is a defined benefit pension?
A ‘defined benefit pension’ (also known as a final salary pension scheme) is a type of pension where an employer provides a lump-sum and an income on retirement which generally goes up with inflation and is guaranteed for life. Usually, the pension income will continue being paid to a spouse when you die. The amount you get paid depends on your earnings, age and length of time working there. Many big employers like Boots, Next and Rolls Royce as well as government departments have traditionally provided defined benefit pension plans and most in the private sector have now closed to new members. That’s partly because they are just too costly to provide, and also because it means companies have enormous, and ever-changing responsibilities to pay pension incomes for years into the future which they would rather not have. These pension liabilities can threaten the existence of entire companies, as we saw with BHS recently.
Pensions for modern times
When many defined benefit pension schemes were originally set up, the average person’s lifespan was a lot shorter and they might only live for a few years after retiring. That’s far from the picture now and most of us will enjoy 20+ years of retirement. That means defined benefit pension schemes are having to pay out for much longer. And the current economic landscape means that’s incredibly costly on the businesses behind them. If a business can’t maintain its pension responsibilities, it will go bust – meaning that you might not get anything like the pension you expected, and jobs are lost.
The proposals in this week’s green paper are designed to relax the rules a little, so pension schemes can cut their likely costs in the future. Specifically, it proposes that pension scheme trustees would have the freedom to change the measure of inflation it uses from the (usually higher) retail prices index to the (usually lower) consumer prices index. What does that actually mean? It means pensions could be less than you originally thought when you come to retire – if this proposal is agreed.
Should I transfer my defined benefit pension?
If it’s right for you to transfer your defined benefit pension, these proposed changes probably aren’t going to make any significant impact on the decision. The reasons why transferring might be a good idea are more complex than that. Equally, if you have a defined benefit pension and you’ve already been recommended to keep it, these changes probably won’t change that advice. But it might change your expectations of what your income will eventually be.
How do I assess the value of my pension?
We always encourage our clients to regularly review their pensions, whether you’re in a defined benefit/final salary pension scheme or a personal pension plan. Understanding the true value of your pension is vital if you want to look forward to a comfortable retirement.
Find out how much your defined benefit/final salary pension is worth by asking the scheme administrator for a Cash Equivalent Transfer Value. Then speak to a pension specialist, like us, for further advice about whether you should keep it or not.
Comparing final salary pension schemes with personal pensions
A final salary pension scheme (defined benefit pension) will guarantee a secure pension income for the rest of your life, which will rise with inflation. Plus, it will pay an income to your spouse and children/dependents after your death. However, if you do not have a spouse, then the pension would simply stop when you die. Moreover, the income is not very flexible, meaning you cannot take more earlier on, especially if you want to begin gradually drawing from your pension as you move from work to retirement. The tax-free sum at the end can be lower than a personal pension plan, with no ability to control investments within the scheme. What’s more, you are relying solely on your employer to keep the pension plan well-funded – in recent times, this is becoming an increasing worry, e.g. the BHS pension.
On the other hand, a personal pension plan gives you much more flexibility. You can take income from the pension when you need it, e.g. you could take more early on in your retirement to use for a cruise or a luxury holiday, and then take less later on in life. The flexible way you can take out your income allows for more tax savings, as you can choose the way it is invested. Plus, on your death, the money won’t be lost even if you do not have a surviving spouse or child. However, the flexible nature of a personal pension plan could mean you risk running out of money early on in your retirement – there are no guarantees.
Please download our one-page final salary v personal pension comparison guide for more information.