What Should I Do With My Defined Benefit Pension?

There are two kinds of pension. One that promises to pay you a certain amount of income for the rest of your days (a Defined Benefit - “DB” pension) and another which relies on you building up a “pot” to fund your own retirement (Defined Contribution - DC pension).

Today, we are going to be looking at the former.

Perhaps unsurprisingly, given how we are all living longer on average and how expensive DB pensions are to cover - the UK market has materially moved toward DC structures over the past couple of decades.

By 2024, only 1 in 3 employees were members of Defined Benefit pension schemes, the rest were all in DC. And DB members are overwhelmingly concentrated within the public sector - government workers, teachers, police etc. The private sector have largely binned these schemes off due to the cost.

The first thing to say, is that a Defined Benefit pension offers an extremely valuable benefit.

Once you reach “Normal Retirement Age" whoever is on the other end of the pension will pay a set income, often linked to inflation, for the rest of your life.

Let’s say you stand to receive a DB pension worth £20,000 a year from the age of 67. This is also the age where the State Pension kicks in, and so from that point you will be able to receive £32,548 in gross of tax annual income every year until the day you die.

No looking at markets, no worrying about running out, the money lands in your bank account every month like clockwork. A healthy level of income coming in that will act as the foundation of your retirement funding, which you can top up using any other savings for the fun stuff.

Now the word “gross” above is doing a bit of heavy lifting, because income from a DB pension is taxable at “non-savings” income rates - 20% for a Basic Rate Taxpayer, 40% for Higher and 45% for Additional Rate in England, Wales and Northern Ireland.

However, tax on DB pensions is collected through the same “Pay As Your Earn” system that we all pay tax automatically through when we are employed. And if you are receiving the State Pension at the same time, the tax code applied to your DB income will often change to reflect the tax due on your State Pension income (because the State Pension is always paid without tax being deducted first).

I know, it can be a bit confusing.

How much will I get?

The amount of income paid out will depend on a number of factors, the main ones being - how long you worked for the relevant employer, when you choose to retire and what type of Defined Benefit scheme you are in.

The main two types of DB pension are:

1. Final salary schemes. Your pension is based on your salary at or close to retirement multiplied by your years of service in the job and an accrual rate (e.g. 1/60th or 1/80th per year). These schemes reward long service and rising pay, since the whole pension is pegged to your end-of-career salary. These are less common now as they are typically more generous.

   
   

2. Career average schemes (CARE schemes). Your pension builds up as a slice of each year’s salary, and each slice is revalued (uprated for inflation, often plus a margin) until retirement. The slices are then added together when you retire. This has become the dominant DB model, especially after public sector schemes were reformed from final salary to CARE in 2014/2015.

   
   

Each year while you are working, your pension administrator will write to you with a projection of what you currently stand to receive as an income on retirement. So you can have an idea of where you are at in real-time.

Regardless of what type of DB pension you are in, these arrangements will often also pay a guaranteed income to your spouse or children if you were to pre-decease them while drawing your pension, and a lump sum if you pass away while in the job.

Sounds great. What do I need to do?

Very little if you don’t want to. While you are working, “standard” contributions into these schemes are handled automatically by your employer.

If you want to “buy more pension” - many schemes (especially public sector ones) let you pay additional contributions to purchase a set amount of extra annual income in retirement.

Most DB schemes also offer what is called an “Additional Voluntary Contribution” (AVC) arrangement - you pay into a separate “Defined Contribution” pension pot to be invested alongside your Defined Benefit pension.

If you want to, you can also choose to make additional contributions into a separate personal pension if you wish.

The key “watch out” here is that any contributions you make into either a Defined Benefit or Defined Contribution pension are subject to the “annual pension contribution allowance” - the cap on what you can put into pensions during the course of a tax year and still receive Income Tax relief. If you exceed this amount, you will be stung with a tax charge. Which isn’t ideal.

For Defined Contribution pension contributions the relevant amount for the calculation of this “annual allowance” is very easy to discern - it is the amount which goes into your pension during the course of the tax year, after any tax relief has been added.

Sadly for Defined Benefit pensions, this figure is less clear - it’s the growth in the capital value of your benefits over the tax year, which is primarily driven by inflation.

Because we cannot know in advance what inflation will be, we cannot exactly know how much will have been deemed to have been added to your pension during the relevant tax year. In effect, we are trying to hit a moving target when it comes to making contributions.

What about at retirement?

As you get closer to your “normal retirement age” your pension administrator will once again write to you with a breakdown of your options. So from a practical perspective it is super important you keep your address up to date with them.

The two main decisions you have to make at this point are:

1. When do I start taking my pension?: If you decide to take your pension before or after the “normal retirement age”, you will receive a lower or higher income. How much the income varies by will depend on the “early and late retirement factors” applied by the scheme.

   
   

   Early retirement factor: take your pension early and it’s reduced, because the income has to be paid for longer - typically by around 4–5% per year, and the cut is permanent i.e. you will receive the reduced amount for the rest of your life.

   
   

   Late retirement factor: take it late and it’s increased, because the scheme only has to fund your income for a shorter period of time.

   
   

2. How much “tax free cash” do I want?: This is the other big decision to make. Most schemes will allow you to exchange some of your lifetime income for a tax free lump sum, to do with what you wish immediately.

   
   

   Now giving up any amount of income for life is a big decision, so it is important to think carefully before doing this. The question is complicated somewhat by the amount of tax free cash you get for giving up £1 of lifetime income (referred to as the “commutation factor” in the lingo) varying from scheme to scheme.

   
   

   A “good” commutation factor is generally thought of as being anything more than 20 - i.e. giving up £1 of income gets you £20 of tax free cash. But there is no “one size fits all” answer here.

Is there anything else to be aware of?

A couple things, yes.

As I have mentioned above, supporting a Defined Benefit pension scheme is expensive. As a consequence, a lot of public sector pensions (e.g. the Teachers’ Pension, Civil Service and NHS pensions) are unfunded.

What this means is that the income which is paid out to retirees is not funded from a big pool of existing money, but from contributions from current employees. Gulp.

The major exception to this is the Local Government Pension Scheme, which is entirely funded - gold star for them. Private sector DB schemes also have to be fully funded by law.

Despite this, things can occasionally go wrong. If a private sector DB pension scheme is unable to pay its liabilities, the “Pension Protection Fund” will step in and pay (less generous) benefits to those unlucky affected members of the defunct pension scheme.

The final thing to say is that it is possible to transfer your Defined Benefit pension into a Defined Contribution pension, should you so wish.

However, this is an extremely important decision with potentially very high downside and if you want to do this you will have to take advice from a specialist regulated financial adviser. There have been a number of unscrupulous advisers acting in this space historically so please, please be careful if this is a road you want to go down.

Crikey. That was a lot this week. Have a great weekend.

None of the above is intended to represent advice to any individual. If you have any queries regarding your situation, feel free to contact me at david@beechgrovefinancialplanning.co.uk or consult with another regulated financial adviser.

Beechgrove Financial Planning is a trading style of Sylva Financial Planning (FCA number 523565). Sylva Financial Planning are not regulated to provide advice on the transfer of Defined Benefit pension schemes.