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Final Salary vs Defined Contribution

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    Final Salary Vs Defined Contribution pensions - boxing match versus

    In the UK personal pensions are the most popular way to fund retirement and your pension pot is normally built up through a workplace scheme. There are two types of workplace pension scheme –  a Final Salary pension (also known as a Defined benefit or DB pension) or a Defined Contribution (DC) Pension. These two pension schemes are very different and the kind of pension you have can affect how much, how and when you can access your money in retirement. It’s important that you understand how this could affect you in retirement. So what are the key differences between final salary pension vs defined contribution?

    A Final Salary Pension guarantees a fixed retirement income for life (protected against inflation). Defined Contribution Pensions build up a pension pot whose value is dependent on the performance of its investment and they may be flexibly accessed from 55.  

    Sweeping Pension freedoms introduced in 2014 have impacted the Pension Industry but some changes are not applicable to Final Salary Pensions. In recent years these dramatic changes to Pension rules have seen a flood of people transferring their Final Salary Pension to take advantage of freedoms enjoyed by those with a Defined Contribution scheme. With over £14.3 billion of funds transferred between April 2017 and 2018, more and more are choosing to opt out.

    Building your Pension Pot

    How you build your pension pot is the same for Defined Contribution and Defined Benefit schemes. Both employee and employer make contributions to your pension pot and you receive tax relief from the government on your contributions.

    Defined Benefit schemes are generally more generous in terms of employer contributions than Defined Contribution schemes. In 2016, prior to the full auto-enrolment roll out average total contribution rate for workplace defined contribution (DC) pension schemes in the private sector was 4.2% of pensionable earnings (Office for National Statistics) with employers contributing 3.2%. For private sector defined benefit (DB) pension schemes, the average total contribution rate was 22.7% of pensionable earnings with members contributing 5.8% of their pensionable pay and employers contributing 16.9%.

    Here’s a quick summary of the main differences between Final Salary and Defined Contribution Pensions 

     Defined Benefit SchemeDefined Contribution
    FlexibilityFixed, guaranteed pension income increases each year to help protect against inflation.

    If you want to take tax-free cash you must take your pension at the same time.
    If you decide against taking an annuity then the level of income taken can be changed at any time. It can be increased or decreased to suit your needs at a particular time. However, there is a possibility your fund could run out.
    Tax-Free CashIn most DB schemes some of the income can be reduced and converted into tax-free cash. However, this is often less than is available under a DC arrangement. Tax-free cash must be taken in one go.Tax-free cash is normally 25% of the total amount of the benefits being taken, or 25% of the member’s remaining available lifetime allowance, whichever is the lower. The tax-free cash can be taken in stages rather than in one go. Tax treatment depends on your individual circumstances.
    Death Benefits & InheritanceDeath Benefits are usually in the form of a dependant’s pension and cannot be passed on.

    Dependants scheme pension: recipient always pays income tax at own rate.
    Any remaining benefits can be passed on free of tax before age 75 and at the beneficiaries’ marginal rate of income tax after age 75.
    HealthIf you have health issues this does not change the level of pension income you receive from your DB scheme.You may be able to take advantage of an increased income using an enhanced annuity if you suffer from health issues.
    Investment Choice & ControlInvestment decisions are taken by the trustees. They are responsible for ensuring you receive the benefits you are entitled to and that the investment decisions they take will allow the scheme to meet its liabilitiesThe investment decisions will be yours and so it is essential you are comfortable taking on this responsibility. You will need to determine the level of risk you are prepared to take and make sure you review this regularly.
    Scheme SolvencyThe Pension Protection Fund (PPF) is available to protect members of schemes that are not able to meet their liabilities. Once your scheme is taken on by the PPF you cannot transfer your benefits out. There are restrictions on the benefits that can be provided by the PPF and it is important to understand the caps and restrictions on pension benefits that may apply in these instances.If your pension is provided by an insurance policy the Financial Services Compensation Scheme provides 100% protection should the insurance provider fail.

    Adapted from Scottish Widows. Taking Advantage of Pension Freedoms

    Simon Garber is an Independent Financial Adviser and Pension Transfer Specialist with over 15 years of experience. He's a member of the Personal Finance Society and holds the coveted Gold Standard for Pension Transfer Advice.

    He is the Managing Director of 2020 Financial Ltd, Financial Advisors specialising in Retirement Planning & Wealth Management, based in Southampton, Hampshire.

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