By: Tim Bennett
8.11.2019
8.11.2019
Many employers used to offer defined benefit (or “final salary”) pensions. Tim Bennett looks at why these schemes are becoming rare in his updated video.
To Receive Tim’s videos straight to your inbox, please click here
Pension basics (2019) – defined benefit schemes
Defined benefit (a.k.a. “final salary”) pensions used to be very common in both the public and private sectors. Now, however, they are increasingly rare, especially when it comes to companies. Many employers are even trying to persuade any remaining members to give up their rights via pension transfers. So, here is a quick recap on how these schemes work and why they are gradually disappearing.
Background
“Why do I need to save when I have a final salary pension?” was the question a friend of my father once asked. He assumed that he didn’t need to bother, given that he was guaranteed two thirds of his (generous) final salary from the age of 65, index linked. Most employees are not as fortunate these days. Pensions of this type, where the benefit promised to an employee is fixed, are being phased out in the private sector because they have become expensive to run and impose an unknown liability on employers.
Terminology
Anyone trying to understand the world of pensions needs to be aware early on that quite a bit of jargon gets used by the industry. This style of scheme, for example, may be called a final salary arrangement (if the employee is entitled to a pension based on their pre-retirement income), or a defined benefit (DB) scheme, where the amount paid out is anchored to, say, average earnings. The common principle is that an employee has some sort of guaranteed entitlement when they retire that is underwritten by their employer.
Basic mechanics
Whilst no two are likely to be identical, DB schemes share some common traits. Money can be paid in by an employer and an employee, after which it is invested in a range of assets such as equities and bonds. Once an employee hits the minimum retirement age, this type of scheme will usually pay out a fixed income every month, which is often inflation-proofed in some way (for example, by being linked to the consumer prices index).
Key features
Employees generally like these types of scheme for the reason just stated – they know in advance how much income they can expect to receive later. Further, these schemes usually allow for a lump sum withdrawal at the minimum retirement date, should an employee want to make one. They are also portable, in that anyone who leaves an employer, having accrued DB rights, can usually hold onto them, albeit the benefit is deferred until they reach the scheme’s specified retirement age.
That age is typically set at around 60 or 65 (the scheme rules will specify), with a surviving spouse often able to benefit from a percentage of the income accrued should the other spouse die before receiving it. The icing on the cake is that if a pension provider goes bust, the Pension Protection Scheme exists to protect accrued rights.
Solutions
Organisations looking for an exit from these expensive and unpredictable DB obligations are trying two basic routes. The first is reducing the size of the future benefit, via reductions in the speed at which employees build it up and moving people away from final salary incomes towards one based on average earnings. The second is offering scheme members a lump sum to transfer out altogether. We will look at this latter option in more detail in future modules, as what is a good idea for an employer may not necessarily be so for an employee.
To find out more
Feel free to email me on [email protected] or contact an Adviser.
