Pension basics (2019) – defined benefit vs. defined contribution
How do you weigh up older defined benefit schemes against newer defined contribution arrangements? Tim takes a look in his updated video.
Pension basics (2019) – defined benefit vs defined contribution
These days, it is quite common for employees to pick up two types of pension, depending on who they work for over a career. Here, I summarise the main differences between them as a prelude to a separate video that deals with the tricky decision to transfer from one to the other.
More and more employers are phasing out defined benefit (or, what has been known as “final salary”) pensions in favour of defined contribution (or, “money purchase”) arrangements. So, as an employee it is fairly key to know how they both work, especially as employers are now offering many people the opportunity to transfer from one to the other.
On the way in
Defined benefit (DB) schemes put the onus on an employer to fund them to the level needed to provide a future promise in the form of a guaranteed, index-linked, income for the employee. So, although an employer may contribute to such a scheme, all the risk is borne by the scheme provider. Defined contribution (DC) schemes, on the other hand, place the risk on the employee’s shoulders by not making the same promise in the future.
On the way out
In order to encourage people to contribute to these DC schemes, the government offers income tax relief on contributions. In effect this grosses up the amount invested in the scheme at the basic rate of tax, such that every 80p paid in becomes £1 invested. Higher rate and additional rate taxpayers can subsequently claim extra relief (a further 20% and 25% respectively) via the self-assessment tax system.
On the way out
Employees who have defined benefits can expect to receive a lump sum on retirement and an income that is guaranteed for the rest of their lives and will probably be linked to inflation too. Defined contribution schemes also offer a lump sum however, beyond that, the way someone takes benefits is dependent on the choices they make and how much money is in the pot.
In both cases, the lump sum is usually tax-free, with any income from the schemes taxable at the recipient’s income tax rate, after the annual personal allowance has been taken into account.
For a fortunate pool of people, who have built up sizeable pots, there is another headache to deal with, the lifetime allowance.
The lifetime allowance headache
The impact of the lifetime allowance (LTA) is to cap the maximum benefit that can be take from a scheme before an additional tax is levied (a sort of penalty for saving too hard!). The amount will depend on the type of scheme being taxed in this way.
Here, the two types of scheme also diverge. The following slide sums up the situation, should the scheme’s beneficiary die.
In essence, a DB scheme will usually pay out a reduced benefit to a surviving spouse and may even, in some cases, pay something to any remaining children too. However, the scheme then also dies. DC schemes, on the other hand, can be fully passed down to future generations, subject to them not having been crystallised via the purchase of an annuity (an income stream paid by a life assurance company). The tax treatment of the amount inherited then varies slightly depending on the age of the person who dies – it may be tax-free or taxable at the recipient’s income tax rate.
DB to DC?
With DB schemes becoming rarer, as employers try to limit their exposure to pensions, many people who have an existing DB arrangement are being offered what look like sizeable sums to give them up and transfer into a DC arrangement instead. This is a big decision, which is usually irreversible, and which requires careful analysis and consideration. As such, it is dealt with in a separate video.
To find out more
Feel free to email on [email protected] or contact an Adviser to discuss any of the issues raised here in more detail.