n 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 Scheme||Defined Contribution|
|Flexibility||Fixed, 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 Cash||In 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 & Inheritance||Death 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.|
|Health||If 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 & Control||Investment 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 liabilities||The 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 Solvency||The 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.|
Defined Contribution Pensions – How do they work
In a Defined Contribution Pension Scheme, the income you get in retirement depends on several factors including the amount you pay in, the fund’s investment performance, What charges have been taken out of your pot by your pension provider and the choices you make at retirement.
There are several types of defined contribution pension
- Executive pension plan
- Group personal pension
- Master trust pension (eg NEST, NOW pension, the People’s Pension)
- SIPP (Self Invested Personal Pension)
- SSAS (Small Self Administered Schemes)
- Stakeholder pension
For many with a Defined Contribution pension plan offered by an employer, their employer will choose the scheme and therefore make the investment decisions on their members’ behalf. However, once you leave an employer you have the option to switch your pension and have more choice over how your money is invested.
The opportunity to manage your own pension investment offers much more flexibility. There is opportunity as well as risk. According to figures from Prudential, strong market performance has contributed to a 30% increase in UK retirement income over the last 5 years.
Final Salary Pensions – How do they work
A Final Salary Pension guarantees a fixed retirement income for life (protected against inflation). How much you get depends on your salary, how long you’ve worked for your employer and a calculation made under the rules of your pension scheme.
Your pension may also provide a cash lump sum on retirement, protected retirement age as well as death benefits for your spouse or dependent child/children.
Your money is invested and managed by the administrators of your pension scheme. The amount you receive is not dependent on the financial performance of the fund or any charges made by the fund administrators. In the event of the fund becoming insolvent your pension would be protected by the Pension Protection Fund (PPF).
New Pension Rules
Since 2014/15 the new pension rules have affected the way that people are accessing and using their pensions. We explore the effect these rules have on final salary pension vs defined contribution schemes below:
Tax-Free Cash Lump Sum
The pension changes brought in in 2015 allow private pension holders access to a tax-free cash lump sum from their pension. Individuals can access this lump sum without needing to draw the rest of their pension.
For those in a Defined Contribution Pension, they can access 25% tax-free and then opt to do a number of things with the remaining pension
- Leave their pension pot invested and continue to pay into it.
- Move their pension into income drawdown and start to take an income, which will be taxed at their marginal rate.
- Take all of the money as a cash lump sum (you pay income tax at your marginal rate on the remaining 75% of your pension).
- Buy an annuity to provide a lifetime’s secure income.
- Use a combination of the above.
With a Final Salary Pension, whilst you may be offered a cash lump sum on retirement, the calculation used to determine your cash lump sum is based on the scheme’s own rules and often results in you receiving less than 25% of your pension pot. It is often the case that you could access a larger tax-free lump sum if you were to transfer to a Defined Contribution Personal Pension.
Tax-free cash and commutation
Some schemes, mainly public sector schemes give members separate entitlements to tax-free cash, most offer tax-free cash by commutation. Commutation involves giving up an amount of accrued pension income in exchange for tax-free cash.
As with pension benefits, the commutation factor will vary from scheme to scheme. For example, a 12:1 commutation factor will mean a £1 reduction in pension for every £12 of tax-free cash.
Christine is due to receive an indexed linked pension of £15,000 a year. Her scheme has a 12:1 commutation factor. She takes the option of receiving £36,000 tax-free lump sum in exchange for a £3,000 year reduction in pension (12 X £3,000 = £36,000).
If she lives for 20 years past retirement she will have swapped £60,000 worth of pension benefit (20 years x £3000 reduction) for her £36,000 cash.
When can you take your Tax-Free Lump Sum?
If you have a Defined Contribution Pension you can access your money once you reach 55.
However, if you have Final Salary Pension your scheme decides when you can access any cash lump sum. You normally won’t be able to access your cash lump sum until your schemes pensionable age. Some schemes may allow you to retire early and therefore access your tax-free cash but you will usually have to accept a lower annual income in exchange for early retirement. It is important to check the rules with your pension scheme administrators.
How can you take your Cash Lump Sum?
With a Defined Contribution Pension, your Cash Lump Sum can be taken as a single lump sum or in chunks spread over your retirement. The first 25% withdrawn will be tax-free. You may opt to take it and leave the rest of your pension invested plus continue to build your pension. Be aware that once you withdraw more than your 25% tax-free pension commencement lump sum, your annual allowance for pension contributions drops from £40,000 to £4,000 per year. This is known as The Money Purchase Annual Allowance (MPAA).
For Final Salary Pension holders, your lump sum must be taken in one go and normally the scheme pension must be taken at the same time. You won’t be able to take the cash lump sum and then defer retirement for a higher retirement income.
Access from 55
The most drastic change to the pension industry introduced by the 2015 Pension freedoms was the ability for anyone with a private pension access to their pension pot from 55, but this only applies to those in defined contribution scheme
If you have a defined contribution pension, not only can you can access a 25% tax-free lump sum at 55, but you can access your entire pension pot. For those seeking an early retirement, the option of being able to access their savings at 55 is very attractive.
If you are a member of a Final Salary Pension Scheme, however, your pension will not become due until the scheme’s pensionable age. Most schemes do give you the option to forgo some of your pension income in return for an early retirement, but the age that you can do this at and the amount it will cost you to do so are decided by your pension scheme administrators. Outside of the rules set out by your scheme, the only way to access your money is to transfer your pension out of the scheme and forgo the benefits and guarantees of your pension.
In some cases, i.e. ill health, your Final Salary pension scheme administrator may consider applications for early retirement but the value of the benefits you will receive will be adjusted and you may receive considerably less than you had previously been forecasted.
If you have a Defined Contribution pension you can opt to go into Flexible Drawdown (try the pension drawdown calculator).
The amount you can withdraw used to be tied to Annuity rates known as capped drawdown, limiting how much you could withdraw in any one year, this is no longer the case. The amount you can withdraw from your pension is flexible. You can take more when you need it and less when you don’t and it can be a useful way of managing your tax liability and/or your changing income needs through retirement.
This does bring the added responsibility of making sensible decisions about your money to manage a sustainable income that will last you through retirement.
With a Final Salary Pension, there is no flexible access. The amount you receive every year is fixed. You cannot opt to take more in one year and less in another or more at the start of your retirement and less when you get older. The graph below shows how retirement costs can change over time.
The Lifetime Allowance (LTA) is a limit on the value of payouts from your pension schemes that can be made without triggering an extra tax charge.
It was reduced in 2016 and is currently set at £1,030,000. The Government has indicated that it will increase each year in line with inflation. Once you exceed this amount, you’ll pay 55% if you take your money as a lump sum or 25% tax if you take it as income.
How is Lifetime Allowance Calculated for Final Salary Pensions?
Lifetime allowance is calculated by your pension provider and is usually worked out on 20 times your first year’s pension plus your lump sum. This means someone with a £50,000-a-year pension income would still fall within the new £1,030,000 limit and could avoid the tax. If you do exceed the LTA, your Pension Scheme Administrator will take the tax from your pension as soon as you start drawing it. The amount you receive will be reduced accordingly.
How is it worked out and payable for Defined Contribution Pensions?
For savers with defined contribution pensions, the lifetime limit is simply compared with the overall fund value.
Current tax rules allow for wealthy individuals to use Flexible Drawdown to defer the Lifetime Allowance Tax until they are 75. This can be achieved by keeping drawings within the LTA limits up to age 75 and gaining the benefit of a largely tax-exempt investment account until that date when the surcharge tax will become due on the excess value of the fund.
If you have no need for the funds in excess of the LTA then you could consider leaving these invested in your pension. Although you have to pay the LTA charge of 25% at age 75, the funds will remain outside of your estate. If you die after your 75th birthday your ultimate beneficiaries will have to pay income tax on the benefits but this may be preferable to you paying income tax on the income and inheritance tax (currently 40%) on any funds that remain in your estate.
Inheriting a Pension
Changes to Inheritance tax rules in October 2014 brought greater flexibility over who can inherit your pension. Private Pensions in drawdown can now be left as a legacy to any beneficiary that you nominate.
Another key difference between final salary pension vs defined contribution is that the flexible rules surrounding who can inherit your pension do not apply if you have a Final Salary Pension.
If you have a Final Salary Pension it is your Pension Scheme administrator who decides who can inherit your Pension; along with the amount they will receive. Depending on the scheme you are in, they will normally only pay a reduced pension, usually half, but some more generous schemes may provide up to two-thirds to your spouse when you die. If you are unmarried and cohabiting there may be rules around your partner’s eligibility to inherit your pension. Your beneficiary cannot nominate anyone to receive any remaining amount if they die. For full details visit What happens to your final salary pension when you die?
Rules around Inheritance tax were changed in 2014. Since the new rules were put in place personal pensions now fall outside of your estate and are therefore not liable for inheritance tax.
Inheritance tax over the allowable threshold is currently charged at 40% so a personal pension can be an extremely tax-efficient way of passing on wealth.
Wealthy individuals are using Personal Pensions as tax vehicles to legally and legitimately reduce their loved ones’ inheritance tax liability. If you die before your 75th birthday and your beneficiary/beneficiaries take the money within 2 years they won’t pay income tax. However, if you are over 75 when you die, they will be charged income tax at their marginal rate.
If you have a Defined Benefit Pension that offers a dependant’s pension the recipient will always pay income tax on it at their own marginal rate.
Cash Lump Sums and Inheritance tax
It is important to note that regardless of whether you have a Final Salary (defined benefit) pension or a Defined Contribution pension, once you take money from your pension as cash it becomes part of your estate and liable for inheritance tax of up to 40%.
So if you have a drawdown pension you should carefully consider whether or not to take your full cash free lump sum or leave your money invested.
About the Author
Simon Garber DIP PFS is an Independent Financial Advisor and Qualified Pension Transfer Specialist. He is the Managing Director and Founder of 2020 Financial, based in Southampton, Hampshire. Simon specialises in Pensions and Retirement planning and is a later life planning specialist. He also holds qualifications in investment and life insurance and is a member of the Personal Finance Society and Chartered Insurance Institute.
Simon is passionate about providing the highest standards of customer care and transparency. 2020 Financial were awarded the Pension Gold Standard in 2019. You can find out more about Simon here.
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This guide does not constitute personal advice, nor should it be treated as such. It is provided for general information and it is vital (and in most cases a regulatory requirement) that you contact a Qualified Pension Transfer Specialist for personal financial advice and obtain a recommendation to transfer before opting out.
- If you are a member of a pension scheme with safeguarded benefits, it is likely it would be in your best interests to retain the safeguarded benefits.
- Make sure you understand all the risks before investing.
- The value of investments and the income they produce can fall as well as rise and you may not get back your original investment. Once you transfer, you will become responsible for the management of your investments.
- Any information contained within this website should not be deemed to constitute investment advice and should not be relied upon as the basis for a decision to enter into a transaction, or as the basis for any financial or investment decision. Investors should always seek professional advice in regard to the suitability of any investment.