The Benefits of Defined Benefit Pension Schemes

Feb 23, 2024 | Pensions

In the ever-evolving landscape of retirement planning, it’s crucial to explore the various pension schemes available. One such option, the Defined Benefit (DB) scheme, has been a cornerstone of retirement security for many individuals. In this article, we’ll dive into the heart of DB schemes and unveil their unique advantages and disadvantages.

What is a DB Scheme?

A Defined Benefit (DB) pension scheme is a promise made to you based on three key factors:

  1. Years of Service: The member’s tenure in the pension scheme.
  2. Pensionable Salary: The member’s income upon which the pension calculation is based.
  3. Accrual Rate: The rate at which pension benefits accumulate over time.

Some public sector schemes like the National Health Service (NHS) scheme often sweeten the deal with a tax-free lump sum in addition to a regular income. It’s worth noting, though, that for non-UK residents, the tax-free lump sum may require some tax planning guidance.

In contrast, private sector DB schemes offer an intriguing option known as “commutation.” This allows members to trade a portion of their annual pension income for a lump sum, providing flexibility in financial planning.

Why DB Schemes Are Safe

One of the most compelling aspects of DB schemes is their cushioning from investment market volatility. Instead of you taking on the risk of investments, it’s your employer who shoulders this burden, ensuring that the promised pension income remains secure. This commitment extends for a lifetime, even when the exact duration is unknown.

Most DB schemes are contributory, requiring employees to contribute a fixed percentage of their salary. Trustees, acting as stewards of the scheme’s assets, play a pivotal role in safeguarding these assets and ensuring sufficient funding to meet liabilities.

Additionally, DB schemes are bound by statutory requirements to increase pension payments, ensuring that members’ benefits keep pace with inflation. When members leave a scheme with preserved benefits, these benefits are retained within the scheme and adjusted to the retirement date.

Weighing the Pros and Cons

Here’s a summary of the advantages and disadvantages of DB schemes:

Advantages:

  1. Predictable Retirement Income: Members can calculate their retirement benefits with confidence.
  2. Staff Retention: Employers often use DB schemes to retain valuable employees, especially as these schemes become less common.
  3. Inflation Protection: Statutory revaluation safeguards members against the impact of inflation.
  4. Zero Investment Risk: Members enjoy peace of mind, knowing that investment risks are the employer’s responsibility.

Disadvantages:

  1. Employer and Scheme Shoulder Investment Risk: Employers bear the brunt of investment risks, which can impact scheme sustainability.
  2. Administrative Complexities: The scheme must appoint trustees, actuaries, and auditors, and establish a formal costing structure.
  3. Compensation Scheme Contributions: The scheme contributes to compensation schemes, which can add to overall costs.
  4. Insolvency Risks: If an employer faces insolvency, the scheme may enter the Pension Protection Fund, potentially reducing promised pensions.

It’s evident that the benefits of a DB scheme primarily favour the member. Consequently, employers have taken steps to mitigate their costs, including:

  • Closing the scheme to new members or all members.
  • Reducing the accrual rate or increasing the normal retirement age.
  • Adopting career average schemes that consider an individual’s average revalued earnings over their entire scheme participation.
  • Adjusting employee contributions and pension increases to the statutory minimum.

At SJB, we understand that navigating the complexities of DB pensions can be daunting. Whether to keep or transfer your DB pension requires careful consideration, and our expert team is here to guide you through this important decision.

This communication is for informational purposes only based on our understanding of current legislation and practices which are subject to change and are not intended to constitute, and should not be construed as, investment advice, investment recommendations or investment research. You should seek advice from a professional adviser before embarking on any financial planning activity. Whilst every effort has been made to ensure the information contained in this communication is correct, we are not responsible for any errors or omissions.

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Personal advice, whenever it suits you.

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