Defined Contribution and Defined Benefit schemes explained

Pension Schemes generally fall into one of two categories, Defined Benefits and Defined Contribution schemes. Whilst most pension products now fall into the Defined Contribution bracket, some employers still offer Defined Benefit pensions.

An iSIPP is a Defined Contribution pension. Whilst Defined Contribution schemes may offer some advantages, like all investment products they are not without their risks. That is why if you are looking to transfer a Defined Benefit to a Defined Contribution Scheme it is important to know the differences and understand what transferring will mean for your pension pot.

Here we will take you through the key features of a Defined Benefit and Defined Contribution pension scheme to help you understand what each has to offer.

What is a Defined Benefit pension?

A Defined Benefit pension, also referred to as a ‘final salary’ or ‘career average’ pension, tend to be workplace pensions. These are pensions that your employer arranges. These types of pension scheme pay a guaranteed amount each year once you retire. Your salary as well as other factors such as how long you have worked for your employer will determine the amount you receive in retirement. Defined Benefit pensions provide a fixed retirement income for the rest of your life. This means you can be confident you will not run out of money in retirement.

However, Defined Benefit pensions are now rare. This is because they tend to be expensive for employers to run. Large public sector organisations like healthcare or educational institutions, may still offer them.

Here are some of the key features and considerations of a Defined Benefit pension scheme:

• -Pension income is linked to final salary and length of employment.
• -You are guaranteed a certain level of pension income payable for life when you retire.
• -Valuable, safeguarded / guaranteed rights and benefits are provided.
• -You may be able to retire early on a reduced guaranteed pension.
• -Your Scheme may provide for a guaranteed level of benefits to your beneficiaries in the event of your death.
• -Investment performance is irrelevant.
• -Access to the Pension Protection Fund.
• -Potential for the employer to go bust and not pay the pension as promised.

What is a Defined Contribution Pension?

The most common type of pensions are Defined Contribution schemes. They can be a private pension arranged by you, such as an iSIPP, or your employer can set one up. The amount you receive at retirement is dependent on the amount you have contributed and how well your investments have performed.

Unlike a Defined Benefit scheme, with a Defined Contribution scheme you can decide how you access your pension (usually after age 55). Another way Defined Contributions differ to Defined Benefit schemes is that Defined Contribution pensions are investment products. This means the value of your pension pot can go up or down and it is possible to receive less than you have contributed.

Here are some of the key features and considerations of a Defined Contribution pension scheme:

• -Complete flexibility in how you receive your pension income.
• -Greater control over investments.
• -Ability to consolidate several pension funds together in one place.
• -Flexibility as to when you take benefits from age 55 onwards.
• -Control over the level of pension income you receive and when.
• -You remain in control of your investments whilst taking pension income.
• -Pension income payments can depend on the performance of the investments.
• -Value of investments can go down as well as up.
• -The value of your fund can erode more quickly depending on performance and surrender charges.

Tax on Defined Benefit and Defined Contribution Pensions at retirement

Taxes are the same for Defined Contribution Pensions and Defined Benefit Schemes. You will need to pay income tax on the benefits you receive in retirement. However, you can take 25% of your pension tax free. Usually, you will need to sacrifice some of your annual income from a Defined Benefit Scheme to make use of this. However, with a Defined Contribution scheme, there are several options available for making use of your 25% tax free amount.

Transferring Your Defined Benefits Pension.

It is possible to transfer out of a Defined Benefits Scheme to a Defined Contribution scheme such as an iSIPP. However, before transferring out of a Defined Benefits scheme to a Defined Contribution scheme, there are certain things you should consider.

It is important to understand you will be giving up future entitlement to a guaranteed pension and other associated benefits and replacing them with a cash value.  Investments are then made within a pension scheme that provides you with greater flexibility and control.

This flexibility and control means that the value of your investments can go down as well as up, and you may not get back as much as you initially invested.

The Financial Conduct Authority (FCA)’s view is that in most cases you are likely to be worse off if you transfer your Defined Benefits pension. However, there are potential benefits and risks when transferring out of a Defined Benefits scheme into a Defined Contribution scheme. The FCA have provided you, the consumer, with free-to access information about transferring your Defined Benefit pension. This can be found here.

Retiring with a Defined Contribution scheme

When invested in a Defined Contribution scheme, at retirement you will need to make sure that there is sufficient liquidity (availability of cash) within your scheme to withdraw a tax-free lump sum (PCLS) and / or income. One of the features of a Defined Contribution scheme, which is not available within a Defined Benefits scheme, is that the type of investments you select can have an impact on the availability of liquidity, as well as the overall impact on the value of your SIPP; this includes any potential surrender charges.

Transfer Advice

If the value of your Defined Benefit scheme is more that £30,000.00, you are required by law to have taken regulated financial advice before the transfer can proceed. Information on this is provided by MoneyHelper. FCA rules require firms advising on pension transfers to have specific permissions. Advice on pension transfers must be given, or checked, by a pension transfer specialist. The pension transfer specialist must follow the FCA’s training and competency rules, and have the appropriate qualifications, and with that, the permission to perform the function.

Conclusion

Whilst many people will already have a Defined Contribution pension through their employer, it is important to find out which type of pension scheme you have before transferring out to a new Defined Contribution Scheme. Whilst Defined Contribution schemes offer greater flexibility and choice when accessing and investing your pension, the money available at retirement is finite and there are certain risks to consider as with any investment product.  For further information on the different types of pension visit MoneyHelper, the UK government’s free impartial pension information service.

Disclaimer 

The content of this article is for general information purposes only and should not be construed as legal, financial or taxation advice. You should not rely on the information contained in this article as legal, financial or taxation advice. The content of this article is based on information currently available to us, and the current laws in force in the UK. The content does not take account of individual circumstances and may not reflect recent changes in the law since the date it was created. It is essential that detailed financial and tax advice should be sought in both jurisdictions and any legal advice, if required.

This notice cannot disclose all the risks associated with the products we make available to you. When making your own investment decisions it is important you understand that all investments can fall as well as rise in value and it is possible you may get back less than what you have paid in. You should also be satisfied that any investments you choose are suitable for you in the light of your circumstances and financial position. You should seek financial advice if you are not sure of what’s best for your situation.