What is a Defined Benefit Pension Scheme?

You would need to have had your head in the sand to have missed that the construction giant Carillion has gone into liquidation. To add to their employees’ woes, it has now been disclosed that the pension Scheme has at least a £990 million deficit. What does this all mean for the members of the Carillion Pension Scheme?

In this blog, I will look at what is a Defined Benefit Scheme? And then in next week’s Blog, I will look at the implications of this deficit on Carillion workers and other Schemes that go into the Pension Protection Fund (PPF).

What is a Defined Benefit Pension Scheme?

A Defined Benefit Pension Scheme essentially gives the Scheme members the promise of a pension based upon the member’s length of service in years, their earnings usually either their final salary or Career Average Earnings and the accrual rate.

What is the accrual rate?

The accrual rate in the figure used to calculate the pension that will be received. It is usually either 1/60th or 1/80th of earnings for each year of service. The lower the accrual rate, the more generous the Scheme.

How are pensions calculated?

So for example if Bob had been in a Final Salary Scheme for 10 years and was earning £30,000 and the Scheme had an accrual rate of 1/60th Bob would have the promise of a pension of £5,000 per annum (30,000/60×10). If it was a 1/80th Scheme, the pension would be £3,750 per annum.

Defined Benefit Pension Schemes will pay income that increases each year with inflation. How the increases are calculated will depend upon the Scheme rules.

When can you take your Defined Benefit Pension?

The Scheme will have a normal retirement date. This is usually 65 but some Schemes will differ. You can sometimes take your pension earlier however, the amount you will receive is likely to be reduced.

Can you take a lump sum?

Most Schemes will allow you to take a lump sum. This will either be built up separately to the pension or, the pension will be reduced to provide a lump sum. The Scheme will have a formula to calculate how much pension is given up for each £1 of lump sum you take. This is called the commutation factor. The lump sum amount will be capped at an amount specified by the Scheme i.e. you cannot take your whole pension as a lump sum.

Can you take a lump sum without income?

No, if you take any benefits from the Scheme, income will be triggered. The decision is a one off and cannot be reversed.

What is the difference between Final Salary and Career Average Earnings?

The difference between Final Salary and Career Average Earnings Schemes is that the benefits within a Final Salary Scheme will be calculated based upon the individual’s final salary. CARE Average either the whole earnings or the earnings over a number of years to get the figure to base the benefits on.

For example, if Bob was in a CARE Scheme and they calculated benefits on the last 5 years of service, and he had had pay rises over this time, his average earnings over the 5 years would be lower than his final salary of £30,000.

Final Salary Schemes are therefore usually more generous that CARE Schemes.

What are the death benefits?

Death benefits will depend upon the Scheme rules. Usually there would be a 50% spouse’s pension. Some Schemes will pay out to partners/dependent children up to a certain age. Some may pay a lump sum on death for example before taking benefits or within the first 5 years of drawing an income.

What would happen to the pension if I left the company?

If you leave the Company or the Scheme closes, the benefits accrued will be revalued in line with inflation. The rate of increases will depend upon the Scheme rules.

Why doesn’t my employer offer a Defined Benefit Pension?

Defined Benefit Pension Schemes provide brilliant pensions. They also provide a head-ache for the Companies providing them. The Companies have no way of knowing how much they will need to pay out in terms of pensions. If we take Bob as an example, his employer will pay him £5,000 from age 65 for the rest of his life and this amount will increase each year with inflation. When Bob dies at an unknown age, the Scheme will then have to pay his spouse for the rest of her life until she dies at an unknown age.

If both Bob and his wife (Bev) lived to their life expectancy, Bev is 10 years younger than Bob and inflation was 3% a year, the Scheme would pay out a total of £263,898.76 to Bob and Bev.

In reality the Scheme has no way of knowing how much it will need to pay for Bob or any other members of the Scheme. Schemes will have liabilities until the last member or spouses of a member dies.

These Schemes are costly to companies and therefore, very few if any are still open to new entrants.

Why are there deficits?

Because there is no way of know how much the Schemes will need to pay out for their members, actuaries carry out calculations to see if there is sufficient money within their Scheme to pay their liabilities. These calculations are based on so many different unknowns such as investment returns, inflation and life expectancy, it is a bit of a finger in the air. However, the calculations give an indication of how well funded the Scheme is. The deficit within the Carillion Pension Scheme of £990 million has built up due to insufficient payments into the Scheme from the company and is based upon actuarial calculations and assumptions.

Unlike Defined Contribution Pension Schemes where individuals have their own pot of money, Defined Benefit pensions are held in one big pot for all of the members. Members do not have individual pots of money assigned to them.

Who looks after Defined Benefit Pensions?

Every Defined Benefit Pension Scheme will have Trustees appointed to look after the money within the Scheme for the interest of the members. The trustees will be independent or member nominated and will meet on a regular basis to review the scheme and its investments.

What happens to defined benefit pensions when the company goes into liquidation?

When a company goes into liquidation, the benefits will go into the pension protection fund (PPF). You can read more in my blog “What is the Pension protection Fund?”

If you would like to find out more about Defined Contribution pensions read my previous blog “What is a pension?”

Get in touch if you want to discuss your pensions and retirement planning.

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