It is important that people are aware of the type of workplace pension pot they’re saving in because a defined contribution pension scheme is different to a defined benefit one.
A defined benefit pension guarantees a stable retirement income for life and it’s based on:
- the employee’s final salary or an average salary throughout their career
- how long they’ve worked for that employer.
Therefore, there are two types of defined benefit schemes: a final salary and a career average.
Nowadays, a defined contribution scheme is preferred to a defined benefit one as it places the burden of saving on employees, making it primarily their responsibility to save enough for their retirement. Whereas, in a defined benefit scheme, it’s the employer’s responsibility to ensure that there’s enough savings in the pot for their employees’ retirement plan.
In this simple guide, Husky explains how a defined benefit pension works for an employer and an employee.
What’s the difference between a defined benefit and a defined contribution pension scheme?
It’s important that these two pension schemes are not confused. To clarify their difference, both are workplace pensions but the difference is based on how payments are made into each scheme.
Retirement income from a defined benefit pension is based on an employee’s salary whereas income from a defined contribution pension is based on salary contributions and how well these funds are performing after being invested.
How does a defined benefit pension work?
Retirement income from a defined benefit scheme depends on:
- the salary the employee was paid at the end of their time with that company,
- an average of the salary the employee was paid throughout their career,
- the year’s they’ve worked for this company because the longer they work, the more they save,
- the accrual rate which is an added pension interest rate for being part of a pension scheme.
In a defined benefit workplace pension, the employer makes pension contributions on the behalf of the employee, based on the agreement between the pension provider, the employee and the employer. These pension contributions are saved in a Pension Protection Fund (PPF) which protects members if their defined benefit pension fund becomes insolvent.
What does final salary pension mean?
As explained previously, there’s two types of defined benefit pensions based on how the pension is saved.
Final salary pension is a defined benefit pension which guarantees a pension income based on the employee’s last salary with their then employer. Salary and consequently pension increases the longer an employee works for that company.
What does career average pension mean?
Career average pension is a defined benefit pension which guarantees a pension income based on the employee’s average of their salary during their career with that employer.
Pension allowance and tax relief
The Government rewards those who save into a workplace or personal pension, in the form of tax relief.
Tax relief is automatic when:
- the employer deducts pension pay before deducting Income Tax
- the rate of Income Tax is 20% as the pension provider will instantly claim it back and add it to the pension pot
However, there’s a limit on tax relief. An employee’s contributions can be tax-free up to 100% of their yearly earnings or up to £40,000. This is called an annual allowance. For instance, if an employee is earning £25K per year, £25K of their pension contributions will be tax-free and added to their pension pot, or £40K if it comes first.
When can you take your defined benefit pension?
The earliest an employee can withdraw a workplace pension is 55, with most people withdrawing their pension around 60 to 65. For a defined benefit scheme, the retirement age depends on the scheme.
It is common to withdraw a 25% lump sum of the pot tax-free, while the rest of the pension withdrawals are taxed at the taxable income rate, depending on the scheme’s terms and conditions. It is also common for pension providers to reduce pension income after a lump sum, based on the agreement with the pension provider.
Transferring a defined benefit pension to another pot
Transferring a defined benefit pension is tricky for the employee, compared to a defined contribution pension one.
They could be giving up on benefits such as a guaranteed retirement income for life. In this type of pension, they’re fully aware how much they’ll be withdrawing once they retire.
Certain limitations also arise with a decision such as this one:
- A defined benefit pension cannot be transferred to a defined contribution one once the pension has been accessed and drawn as income.
- It is the law to seek financial advice from a professional for the transfer of a pot worth £30K and more, which could add to further expenses.
- Once the transfer has been authorised, the decision is irreversible, meaning that the pension cannot return to the previous pension provider.
Transferring a defined benefit pension to a defined contribution scheme is a decision that should be taken with caution.
Husky helps you manage your workplace pension
Husky helps both employers and employees get better value out of a workplace pension.
Learn more on how Husky can support you with your workplace pension here.