What Are Defined Benefit Pension Schemes?May 27, 2021
Defined benefit pension schemes are also commonly known as final salary pension schemes and is essentially a pension scheme that promises to pay out an income that is the same as what your final salary was when you retired or left from that company.
Unlike many other schemes, the amount you receive in your retirement is guaranteed and is paid directly to you based on your normal retirement date of the scheme and, as a result, you don’t have to decide how you access your pension pot at any time – other than the usual choice of whether to take out lump sum or not at the start.
Just What Is A Defined Benefit Pension Scheme?
A defined benefit pension scheme is one which you and your employer continually pay into throughout the span of your career. This money is then invested into various investment vehicles over time on your behalf. However, unlike all other types of pension schemes, the amount you pay in is pretty much irrelevant when it comes to calculating your retirement income. This is because the income you receive in your retirement is guaranteed when you first agree on your pension.
There are 2 types of defined benefit pension schemes, one of which is based upon your final salary when you retire, whilst the other is based on the median salary you receive throughout your entire career.
Your pension value will also rise, also known as index-linking, which basically means the income you receive will increase each year, in line with inflation, although the actual increase will most likely be capped.
Defined Benefit Schemes And Their Lump Sum Payments
The UK Government allows retirees to take out an initial lump sum of 25% of the total value of their pension pot, tax free. Unlike other schemes where the final value is a calculation of the total amount invested, defined benefit schemes work a slightly differently.
It is still very possible to take out a lump sum, or perhaps transfer the entire amount of the pension pot altogether, but this totally boils down to how much of the lump sum you receive for every £1 of income you give up. This is called the ‘communication factor’. In simpler terms, if your communication factor is 15, for every £1 you choose to give up, you will receive £15 in return as a lump sum.
In either case, you will need to ask you pension fund provider directly on how much lump sum you will receive from your defined benefit pension scheme.
Expats And Defined Benefit Schemes
As the whole scenario for expats is now slightly different for anyone who stays in the UK, there are extra options and more risks for expats when it comes to defined benefit schemes.
As with any other investment decision, everyone’s circumstances are different and therefore there’s no hard and fast rule or preferred direction and it’s crucial that you get professional advice from a good independent financial adviser or specialist pension advisor near me, who completely understands the ins and outs of defined benefit pension schemes.
As with all investments, the wrong decision can cost you dearly and result in a significant loss.
However, in recent times, the yields of 10 year gilts have declined, which means the cash equivalent values of defined benefit schemes have seen record highs.
Also, as we mentioned earlier, as people continue to live longer, the pension fund deficit (i.e. there’s not enough in the pot to pay everyone) means that there could be a far greater risk to their income in the long term. It’s estimated that the deficit of defined benefit pensions is growing by a staggering £100bn every month, and is currently estimated at £1.54tn (according to PwC).