Defined Benefit and Defined Contribution pension schemes

Introduction

In this article, Specialist Financial Adviser from Wesleyan Financial Services, Mark Moroney, highlights the differences between Defined Benefit and Defined Contribution pension schemes.

What are Defined Benefit (DB) pension schemes?

A DB pension is a type of workplace pension which guarantees you a specific income for life (throughout retirement). It is defined by the benefits that the scheme will pay you when you retire, not necessarily what you put into it. DB pension schemes are typically more common in public sector employment.

The Teachers’ Pension Scheme (TPS)

The TPS is a DB Scheme. Its structure is based on your annual pensionable earnings, re-valued each year. Essentially the more you earn, the more you accrue.

Teachers in Scotland, England and Wales are automatically enrolled to the TPS, unless they choose to opt out. The TPS provides you with a guaranteed, index-linked income for your retirement. As long as you’re in eligible employment, you can take your pension with you throughout your teaching career, wherever the job may take you.

There may also be the option to take part of your pension as a tax-free lump sum when you retire. The pension benefits you build up, are based on your service and salary, and are calculated in accordance with the scheme regulations. The value of your pension does not rely on the investment performance of your contributions.

Teachers in Scotland, will likely be part of the Scottish Teachers’ Pension Scheme 2015, and/or the Scottish Teachers Superannuation Scheme (STSS). Both the TPS and the STSS have a final salary and career average revalued earnings (CARE) scheme. Those in England and Wales will be members of the Techers' Pension final salary scheme and/or the career average scheme.

There have been various versions of the TPS over the years, but in 2015, the latest CARE scheme was introduced.

As of April 2022, all members who were still contributing to the scheme were moved into the 2015 scheme and new members are automatically enrolled to it, unless they opt out. Under the CARE scheme, benefits are based on 1/57th of your pensionable earnings in each year you are part of the scheme. This amount is then added to your 'pot' annually, and the total is revalued.

There's no automatic lump sum under the career average scheme, but you do have the option of converting your pension into a lump sum if you wish. The 2015 pension is based on pensionable earnings. Each year 1/57th of the pensionable pay is added to a pot which increases annually by 1.6% plus CPI. At retirement, this pot becomes the pension.

All members would have been enrolled in this scheme as of April 2022 regardless of any previous transitional protections.

Death in service benefits

If you die in service, your surviving spouse or civil partner will automatically be given your death grant. That’s unless you’ve made a death grant nomination to someone else. (To be classed as in ‘pensionable service’, you must be receiving at least half of your usual gross salary.) If you die within 12 months of leaving pensionable service, the in-service death grant still applies. Once 12 months have passed, the out-of-service death grant applies.

You can choose a beneficiary of any age and relationship to you, although you can’t nominate a charity or trust. If there’s no adult beneficiary or death grant nomination at the time of your death, your death grant will be paid to your estate.

After your death, your beneficiary will receive a ‘short term pension’ which is a payment equivalent to three month’s salary. After these three months, they’ll receive a ‘long term pension’, with the value depending on the type of pension membership you held.

Ill health retirement

If you’re unable to work due to your medical condition, you may be eligible to apply for ill-health retirement under the Teachers’ Pension Scheme (TPS), provided certain criteria are met. This means you’ll be able to access your pension benefits before your normal pension age (NPA), and without the usual reduction.

What are Defined Contribution (DC) pension schemes?

A defined contribution (DC) pension – often referred to as a private or personal pension - is different. Here, the amount of pension you get in retirement is defined by the contributions paid into it and investment growth. This means that you build up a pot of money which can be used to provide an income in retirement.

The only element to this type of pension that is controlled, is how much you pay into it. This would be an amount that’s affordable to you – this could be monthly, quarterly, half yearly, in lump sum payments, or whenever you can afford to do so. The funds from private pensions can be put into investment funds of varying risk levels – how much you get back in the future, depends on how much you paid into the pension and how the investments perform.

The annual allowance applies to both DC and DB pensions - the maximum you can pay and receive tax relief is the lower of:

• The annual allowance (the maximum that can be saved within pensions each tax year without a tax charge, currently £60,000) plus any unused annual allowance from the previous three tax years.
• Or, 100% of your gross earnings for the tax year less any other contributions you have made.

With a DC pension, when you retire, instead of having a set amount of income per year as a pension, you would have a set fund value. This could be better described as a savings pot worth a set amount of money - once you reach retirement age, you have several options as to how you choose to use this capital to support you.

One option is to use flexible access drawdown (FAD). This is where you can choose what you draw from your pension without limitations. For example, if you had a pot of £100,000 you could withdraw it all in the first year if you wished to do so – this is not necessarily a sensible strategy due to potential tax implications, but it is possible.

Many people choose to try to protect the capital value of their defined contribution pension by attempting to withdraw an income which closely matches the growth on the fund. For example, if the fund typically grows by an average of 4% then this is the amount that would be withdrawn, withdrawing more than this would risk depleting the fund which could mean it runs out within the person's lifetime.

Private pensions can offer greater flexibility and are often used by teachers to enhance the income from their TPS.  This can be especially beneficial for teachers who take early retirement, to bridge the gap in income before their state pension starts.

What are the key differences between DB and DC pension schemes?

Advantages of DB schemes

• A DB pension scheme offers a guaranteed level of income for life, it doesn’t depend on how the funds perform in the financial market. The security this offers is one of the greatest advantages of a DB pension such as the TPS.
• The cost of replacing the guaranteed income provided by a DB pension, by buying an annuity, (a retirement product offered by insurance companies that lets you exchange some, or all of your pension, for a regular income guaranteed for life) for example, is significantly higher.
• DB pension schemes are typically managed by a board of trustees, this means holders do not have to make decisions regarding the management of the funds.
• Many DB schemes, including the TPS, offer death in service benefits, which may include a lump sum payment, a spouse’s pension and an ill-health retirement pension. If a TPS holder dies before retirement age, a lump sum will be paid to a nominated beneficiary. A pension may also be paid to their dependants.

Disadvantages of DB schemes

• It is not possible to build up a pot of unspent funds within a DB pension to be passed down the generations to nominated beneficiaries.
• DB pensions are fixed by the rules of the scheme they belong to and as such offer less flexibility.
• Whilst it may be possible in some cases to transfer out of some public sector DB schemes to a DC scheme, there are typically very strict restrictions.
• If you take some DB schemes, including the TPS, before normal pension age (NPA), you'll face an early retirement penalty.

Advantages of DC schemes

• It is possible for any unspent funds in a DC scheme, to be passed onto beneficiaries upon death of the holder.
• A DC pension can offer greater flexibility in terms of how and when you access your funds.
• A DC pension can be used to enhance or top up a DB pension.
• There is no penalty for early access of a DC pension from age 55, or age 57 from 2028.

Disadvantages of DC schemes

• A DC pensions offers an unknown income, that is essentially based on the investment performance of your contributions. It is not guaranteed.
• DC pensions can require more involvement from the holder regarding decisions on where the money is invested.

Retirement and wider financial planning vary depending on individual circumstances, and what works for one person may not be suitable for another. For bespoke guidance tailored to suit your specific needs, speak to a Specialist Financial Adviser from Wesleyan Financial Services. They work specifically with those in the education segment, offering support at every stage of your career and beyond into retirement. Charges may apply.

Tax treatment depends on individual circumstances and may be subject to change in future.

Bear in mind that the value of investments can go down as well as up and you may get back less than you invest.