Defined benefit pension plans are the traditional pension schemes often referred to as the gold standard of pensions. In a defined benefit pension scheme, the employer offers the retired employee a monthly sum based on their earnings, age and how long they worked for the company. They became popular after the Second World War, particularly at large corporations and companies such as the BBC, Vauxhall and British Telecom. The benefits paid by the employer are linked to the employee’s salary. As their salary rises, so does the amount they receive on retirement. The employer is responsible for making sure that there are sufficient funds to pay the pension after the retirement of the employee.
Such pension schemes are defined because their benefits are known in advance. In most cases, they are based on the employee’s final salary, which means that the pension benefits are calculated using the employee’s average salary over a number of years at the end of their career.
If you have been paying into a defined benefit contribution pension scheme, your savings plus the contributions from your employer and any government tax relief you have acquired will have been invested in the stock market. However, the income you receive is guaranteed and agreed in advance. Therefore the pension is not dependent on how well the stock market or other investments perform. A defined benefits pension will also rise in line with inflation each year.
Today, defined benefit pension schemes are usually occupational pensions. Final salary schemes are becoming rare. Many are now closed to new members, with more pension plans turning to the less generous career average schemes. These are based on the average of the employee’s earnings during their career and usually result in a smaller monthly pension payment than the final salary schemes.
From next April, people in defined benefits pension schemes, particularly final salary pension plans, will be able to transfer to defined contribution schemes if they wish to. These differ to defined benefit pension plans in that members can choose the fund in which their pension savings will be invested. Members are also able to increase the amount they contribute monthly, which is not possible with a defined benefits scheme. At retirement, members have to use the money that has been accrued through their plan to buy an annuity. They are also able to withdraw as much as 25 per cent as a tax-free lump sum. From April 2015, members of defined contribution schemes will be able to withdraw some or all of their pension funds and invest them or spend them as they wish, although they will have to pay tax on 75 per cent of the sum.
All pension schemes are dependent upon the vagaries of the stock market. Consequently, since the economic crisis of 2008, most final salary schemes have been in deficit. However, the difference between assets and liabilities is narrowing. The future remains uncertain for these schemes, and they are likely to be subject to regulation changes and to government intervention over the coming years.
Because so many pension schemes depend upon the stock market, there is an obvious element of risk involved. Those managing pension schemes have struggled to cope with deficits. Further government intervention is always a potential threat too. Fortunately, there is a range of tools available that will help schemes to manage risk and so become more stable. Many schemes, however, are finding that the task of attaining stability is too difficult to manage on their own. Aon Hewitt offers a guide to managing the various and often competing demands of companies, trustees and pension members.
The future is looking for brighter for pensions than it has done for some time. As the economy revives, there are increased opportunities for pension scheme investment as well as more opportunities for plans to insure against members’ greater life expectancies.