Teachers, NHS workers, police, firefighters and many other public sector workers have a special kind of workplace pension: the defined benefit (or final salary) scheme. But how exactly are these pensions different? How do they work? And in the wake of pension freedom, are they still as attractive as they used to be? Article by Nick Green
What are teachers meant to look forward to (apart from 4 o’clock)? Traditionally one of the perks of the job has been the teacher’s pension – and the same goes for doctors, nurses, firefighters, the police and a host of other public sector roles. Jobs like these come with defined benefit pensions – more commonly known (sometimes inaccurately) as final salary schemes. For many years such schemes have been the envy of the private sector, where they are an endangered species.
But in April 2015 something odd happened. The fabulous defined benefit pension was suddenly in the Cinderella role, as pension freedom appeared like a fairy godmother to grant holders of the other kind of pension (defined contribution) a range of new options. It has left many teachers, firefighters, nurses etc. feeling confused to say the least. You’ve been repeatedly told you had the best kind of pension; now you find yourself excluded from pension reforms that sound really exciting. And you might not even understand why.
Time to pop back to school (groan!) for a refresher lesson in how your defined benefit / final salary pension actually works.
Learn about your defined benefit pension
When people and websites talk about pensions, they’re nearly always referring to defined contribution (DC) pensions, also known as money purchase schemes (with all the different names it’s no wonder people get confused). DC pensions are essentially just a big savings pot: you pay money in and later you draw it out (while in the meantime it’s beefed up with tax relief and compound interest).
A defined benefit (DB) pension works in a completely different way. It doesn’t depend on a saved pot of money, but will pay you an income from the start of your retirement until you die, and often a tax-free lump sum too. How much you receive will depend on your pensionable service (how long you’ve been a member of the scheme), your pensionable earnings (either your salary at retirement, or your average salary over the period of your membership) and the scheme’s accrual rate (the proportion of your salary you receive as pension for each year of service). A typical accrual rate might be 1/80, which means that if you spend 20 years in the scheme, your DB pension would pay you 20/80 (i.e. a quarter) of your final salary. So in this scenario, if you retired on a salary of £40,000 then you’d receive £10,000 a year for the rest of your life.
Most DB schemes will also give you the option of taking a tax-free lump sum at the point of retirement, as well as your guaranteed income for life. In some schemes, taking a lump sum may reduce your annual income, but a lot of public sector pension schemes pay an automatic lump sum in addition to your annual income.
Why doesn’t pension freedom apply to defined benefit schemes?
By now most hands in the class should be up. Pension freedom gives people access to their pot of money from the age of 55, but with DB schemes that pot of money doesn’t exist. These schemes were never designed to pay out the entire pension in one go, but over a period of time.
But I’ve heard I can transfer out of a defined benefit pension scheme
It depends on the kind of DB pension you have. Some schemes (such as the Local Government Pension Scheme or private-sector schemes) are known as funded schemes, because they are supported by a central fund. If you really want to, you can transfer out of these DB schemes. Your pension is then moved into a DC scheme, the size of which would be determined by your pension’s transfer value. Be aware that this value is likely to be significantly less than you would have received over your retirement if you had remained in the DB scheme – the advantage would be that you could access it in a variety of different ways, even all at once.
However, many public sector pensions are ‘unfunded’ schemes – that is, there is no central fund, and they are paid for only by the taxpayer. The pensions of teachers, firefighters, NHS workers, the police and the armed forces all fall into this category. This means it’s not possible to transfer from this kind of pension into a DC scheme – the money simply isn’t there to do this for everyone, so the government ruled it out.
Is it bad to be in a non-transferrable defined benefit scheme?
An unfunded DB pension scheme is actually a very good thing. Although some public sector pensions have become less generous than in the past, in most respects they still outstrip the vast majority of DC pensions out there. Admittedly you won’t have the flexibility enjoyed by those who can access their full pension pot from the age of 55 – but that flexibility is a mixed blessing, and can easily lead to the wrong choices being made.
Is there still flexibility in a defined benefit scheme?
Even if you are locked in to a DB scheme (and it’s a pretty nice place to be locked in) you will still have a degree of flexibility at retirement. With most schemes you can vary considerably the size of the lump sum you receive, and the size of your annual income – increasing one at the expense of the other, or vice versa.
When approaching retirement it can be hard to know how to set up your DB pension benefits – especially as this is a one-off decision that will affect the rest of your life. Financial advice can be a great help at this point. A financial adviser can look at the options offered by your scheme and assess your financial circumstances overall, to help you make your choice with confidence.
Finally, remember that your tax-free lump sum at retirement may be a sizeable amount of money, especially if you’ve been in the job a long time. A financial adviser can show you how to achieve maximum value from it in the ways that suit you best – so you still get a kind of pension freedom after all.