Pensions and retirement planning

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A defined benefit pension scheme, also known as a final salary scheme, is an occupational pension scheme provided by an employer where the level of benefits that a member receives depends several factors, as follows:

Scheme accrual rate

Most private sector defined benefit schemes build up pension benefits at an accrual rate of 1/60th of final pensionable salary for each year of pensionable service. Some offer different rates such as 1/80th or ev...

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Normal pension age

The benefits accrued under the scheme are based on the member retiring at the scheme’s normal pension age, typically age 65. Someone does not have to retire to take benefits and members may now be able to continue working beyond a scheme’s normal pension age.

Which accrual rate would be more beneficial for a scheme member – 1/60th or 1/80th?

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As well as the ‘normal’ defined benefit scheme described in the last section, there are also variations and hybrids. 

Defined benefit variations

The following variations of the ‘normal’ defined benefit scheme also exist:

Defined cash schemes -  These schemes generally limited the benefits so that they all fell within the pre A-Day limits on cash. With the advent of pension simplification, no further accrual can take place on this basis. However, transitional protection allows protection for pre A-Day benefits accumulated on the basis of cash only

​ Career average schemes  - These are schemes where the earnings formula us...

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Final salary underpin - this is a defined contribution scheme with a defined benefit underpin and in many ways a mirror image of the money purchase underpin route. The scheme member is provided with a defined contribution retirement benefit with a minimum level of pension based on final salary. Each member has their own defined contribution account plus a separate unallocated account to meet the cost of the guarantee where there is sufficient in the member’s account. This type of scheme is rare now.

Why are defined benefit occupational schemes increasingly moving across to a career average basis?

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A defined benefit scheme will be established subject to a trust, under which the trustees hold the scheme’s property for the benefit of the members of the scheme and in accordance with trust and pensions legislation.

Normal pension age

The scheme will set a normal pension age (also called normal retirement age) at which the members will usually retire, and up to which the employer will pay contributions. Because men and women must be treated equally, most schemes have equalised their retirement ages at 65 rather than 60.

In practice, there is now only a normal minimum pension age from the HMRC viewpoint, although schemes will continue to operate normal retirement ages as part of their basic structure. However, the Employment Equality (Age) Regulations 2006 mean that members may now have the right to continue working beyond a scheme’s normal retirement age.

Bridging pensions

Some schemes pay a bridging pension - often where the scheme’s normal pension age is lower than State pension age. When normal pension age is reached a higher pension is paid until State pension age at which point it reduces to reflect the State pension.

Contributions

Whilst the pension benefits at retirement are not based on contributions paid into the scheme, there must be an employer contribution into the scheme in order...

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The resulting pension is generally higher than the GMP it replaced, but not as well protected against inflation.

When the new State pension was introduced on 6 April 2016 the additional State pension stopped, and therefore contracting-out also ended, as there is no longer anything to contract out of.

Pension increase exchange (PIE)

Pensions that escalate in payment are expensive for the scheme and increased longevity is making this more expensive. Pension increase exchange is therefore popular; PIE is where the member is offered the option of giving up future guaranteed increases to their pension in exchange for a higher initial pension with no future increases other than statutory increases.

The member has to decide whether the higher level pension offers them a fair value – this is hard for them to assess as it will depend on how long they live and how fast the pension on average is expected to increase.

TPR regard PIE as an incentive exercise and has set out five principles which it expects to be the minimum standard of conduct:

Clear, fair and not misleading

Open and transparent

Manage conflicts of interest

Trustee consultation

Independent financial advice

As well as these principles, a voluntary Code of Good Practice has also been produced.

A key aspect of the management of a defined benefit pension scheme is the valuation of the scheme’s assets and liabilities. This is because the overall position will influence:

The employer’s contributions

The employee's contributions

The scheme’s investment strategy

Risk-based contribution levies to the Pension Protection Fund (PPF);

Transfer values

The employer’s balance sheet

Defined benefit schemes are required by the Pensions Act 2004 to undertake an actuarial valuation every year. However, this can be extended to every 3 years where the scheme’s trustees obtain actuarial reports in the intervening years.

Ongoing scheme valuations

The Pensions Act 2004 introduced a statutory funding objective, often referred to as scheme-specific funding, for private sector defined benefit schemes. The Act talks in terms of ‘technical provisions’ rather than scheme liabilities and requires that every scheme ‘must have sufficient and appropriate asse...

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Investment strategy can be revised. A change of investment strategy can limit the extent to which the deficit can increase if market conditions are poor. Many schemes are moving away from equities towards bonds for this reason

Transferring existing company assets to the scheme; extending the scheme’s normal pension age and changing the definition of pensionable salary from ‘final salary’ to ‘career average earnings’ for future accrual

If major changes are made to the benefit structure of the scheme, the employer must consult with affected employees, such changes include:

Closing the scheme or stopping accrual

Replacing the scheme with a defined contribution scheme

Increasing member contributions

Changing the basis for working out future accrual

What does IAS 19 require of pension schemes?

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Trustees’ responsibilities

Pension scheme trustees have the general responsibilities to act within the Pension scheme trustees have the general responsibilities to act within the provisions of the trust and to hold and invest trust assets for the benefit of the trust’s beneficiaries (scheme members) to achieve the best possible returns. They must act impartially and maintain the pension scheme in the best interests of its members at all times. They also have specific responsibilities as follows:

Must obtain audited accounts (or face criminal penalties)

Must not rely on the advice of an actuary, auditor, investment manager or legal adviser whom they have not appointed themselves

Must draw up a schedule of contributions showing employer and employee contributions and delivery dates

Are obliged to report certain delays in delivery time of contributions of more than 30 days to The Pensions Regulator

Must draw up a statement of investment principles to provide guidance to their investment manag...

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An opinion as to whether contributions have been made in line with the schedule of contributions or payments schedule and if not, explain why 

Where there is no schedule of contributions or payment schedule, a statement as to whether contributions have been made in line with the scheme rules or policy contracts and if not, a statement as to why this has not been done

Scheme administrator

The Finance Act 2004 requires that every pension scheme must have a scheme administrator.

A scheme administrator’s duties would typically include:

Registering the scheme with HMRC

Operating tax relief on contributions under the relief at source system

Reporting events relating to the scheme and the scheme administrator to HMRC

Making returns of information to HMRC

Providing information to scheme members and others in connection with lifetime allowance, benefits and transfers

What could happen to a scheme trustee if they fail to obtain audited accounts?

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As stated earlier the level of benefits that a member receives at normal retirement age depends on the following factors:

Scheme accrual rate

Pensionable service

Pensionable remuneration

The interaction of these factors will determine the l...

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PCLS = [20 x pre-commutation pension x C]/[20 + (3 x C)] where C is the commutation factor used by the scheme.

In this section we explain the rights and options of employees who leave service prior to normal retirement age with accumulated pension rights.

If employees leave their employer’s defined benefit occupational pension scheme prior to retirement, they will usually have the following options:

Retain benefits within the scheme as a “preserved pension”

Transfer benefits to an occupational scheme or group personal pension/stakeholder scheme operated by their present employer. Alternatively transfer benefits to an individual pension or stakeholder plan

Take early retirement benefits

Take a refund of personal contributions paid into the pension scheme

Preserved pensions

An early leaver with two or more years of qualifying service must be offered a preserved pension payable at the scheme’s normal retirement age. It is possible for an employer to offer a preserved pension to members where service is less than two years. Few do, however, preferring to either refund employee contributions or transfer benefits to another scheme.

Preserved benefits from a defined benefit scheme will initially be based on the individual’s service and pensionable salary at leaving accumulated in accordance with the scheme’s accrual rate. For example, for a scheme with a 60ths accrual rate, a member with 20 years’ service at the date of leaving and a pensionable salary at that date of £30,000 would have a preserved benefit of 20/60 x £30,000 = £10,000. Then, from the date of leaving to retirement, they will be revalued in line with the revaluation requirements in the table below.

The accumulated pension benefits and lump sum at retirement will then...

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Early retirement

Scheme members who stop working for the employer may start to draw retirement benefits prior to the scheme’s normal retirement age.

Frequently, if a scheme allows voluntary early retirement it will calculate the accumulated pension benefit to the date of early retirement and then decrease that amount using a discount rate such as 4% for each year that early retirement precedes normal retirement age. In some instances, this rate will be more, some less. Voluntary early retirement will usually be restricted to the minimum ages as set under legislation, i.e. 55.

The above restrictions also apply to those members who simply decide to retire earlier than the scheme’s normal retirement age.

Refund of contributions for early leavers

For those individuals leaving their employer’s defined benefit scheme within the first three months of pensionable service, the only option open to them (as required by law) is a refund of their employee contributions.

Employees leaving after less than 2 years may be entitled to a refund of contributions but this is not obligatory as the scheme may offer a preserved pension.

The tax on employee contributions refunded is as follows:

The first £20,000 of any refund is taxed at 20%

Any excess is taxed at 50%

The tax liability falls on the scheme administrator, who will be able to deduct the tax from the member’s refund. Any interest paid on a refund of contributions is taxed as a scheme administration member payment.

What options are open to an employee aged under 55 who leaves a defined benefit occupational scheme with one year of pensionable service?

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Subject to certain transitional reliefs, drawing benefits before normal minimum pension age (55) is only possible on grounds of ill-health.

The Finance Act 2004 defines an ‘ill-health condition’ which must be met for this to occur. The condition is that the scheme administrator has received evidence from a registered medical practitioner that the member is (and will continue to be) incapable of carrying on the member’s occupation because of physical or mental impairment, and the member has in fact ceased to carry on the member’s occupation. Although the rule implies a permanent condition, the legislation has evolved so that a scheme can suspend or reduce payment of an ill-health pension if the member regains their health.

If the member has a life expectancy of less than one year, it is possible to commute their uncrystallised arrangements for a ‘serious ill-health lump sum’. The lump sum will be paid free of tax (subject to a lifetime allowance test) unless the member is age 75 or over, in which case it is taxable as the recipient’s income via PAYE. The member must have some lifetime allowance remaining and each arrangem...

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Survivor's pensions are usually calculated as a percentage of the member’s pension in payment (e.g. 50%). For calculation purposes, the member’s pension is usually taken as the amount he/she would have received without commuting any of it for a pension commencement lump sum. 

There is no limit on the amount of survivor’s pension that can be drawn if the member dies before their 75 th birthday. If the member dies after age 75 in receipt of a scheme pension, then the survivor’s pension is restricted to 100% of the member’s pension in the year to death, plus 5% of any pension commencement lump sum drawn by the member.

Many schemes allow an allocation option giving retiring members the chance to surrender part of their pensions to increase the potential survivor’s pension.

The Finance Act 2004 defines an ‘ill-health condition’ which must be met for a defined benefit occupational scheme pension to become payable in the event of early retirement due to ill health. State the main elements of this condition that must be adhered to.

Answer : Purchase course for answer

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In-house AVCs

Prior to A-Day, all occupational pension schemes had to offer an in house AVC scheme. Whilst that requirement no longer exists many schemes still retain such schemes. Benefits from an in-house AVC scheme can either accum...

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List the three ways that an in-house AVC can be used to allow a member to top up their benefits in the main scheme.

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Transfer value calculations

In this section, we describe the fundamental basis on which pension transfer values are calculated for defined benefit schemes and the factors which could affect or vary transfer values.

Basics of calculation of transfer value for defined benefit schemes

To explain the basics of how to calculate a member’s transfer value from a defined benefit scheme, we shall work through an example of the four-step process:

Step1: Calculate the member’s pension preserved at the date of leaving

This will be based upon length of service, pensionable salary and the scheme’s accrual rate. In addition the member may have purchased extra service via AVCs or transferred benefits in from previous employments.

As an example, Bob leaves service having accumulated, a pen...

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Within 1 month of receiving the request for a TV trustees must let the member know they must take independent advice

Within 3 months of the date of the application the trustees must issue a statement of entitlement

Within 10 working days of the guarantee date the trustees must give the member the statement of entitlement

Within 3 months of the guarantee date the member must make a further application in writing confirming they wish to transfer. They must also provide the trustee with confirmation that they have received independent t advice from an FCA authorised adviser.

The trustees must check that the member has received the advice

If the receiving pension scheme is willing to accept the transfer, the trustees must then transfer the guaranteed transfer value within 6 months of the guarantee date

All advice in respect of a transfer of safeguarded benefits should result in a personal recommendation. The TVA process has been replaced with an appropriate pension transfer analysis (APTA) and within the process the use of a comparator, called a transfer value comparator (TVC).

The Pensions schemes Act 2021 enables a statutory right to a transfer to be restricted to help combat pension scams. Regulations will be made regarding additional conditions that will need to be met.

An adviser needs to consider the benefits potentially being given up and compare them to the potential benefits after a transfer.

Rules require that all advice regarding transfer of safeguarded benefits results in a personal recommendation. The starting point is that the transfer will not be suitable.

An adviser must consider the client’s:

Intention for accessing pension benefits

Attitude to transfer risk including

- The risks and benefits of staying in the scheme

- The risk and benefits of transferring into a scheme with flexible benefits

- The client’s attitude to guaranteed income

- View on whether they will access funds in an unplanned way impacting on the sustainability of the fund

- Attitude to and experience of managing investments

- Attitude to any restrictions on the ability to access funds in the ceding scheme

Attitude to and understanding of investment risk

Realistic income needs as well as alternative ways to achieve the client’s objectives

Alternative ways to achieve the client’s objectives instead of the transfer

Since 1 October 2020 firms must obtain evidence that a client understands the risks of proceeding with a transfer from a defined benefit scheme. Records must be kept of the evidence and must be received before finalising any recommendation to transfer.

All advice relating to the transfer of safeguarded benefits must be given or checked by a pension transfer specialist.

Appropriate pension transfer analysis (APTA)

The objective of the APTA is to demonstrate the suitability of the personal recommendation.

A firm has to assess the benefits of the ceding scheme and compare these with the benefits and options under the alternative proposed arrangement.

An adviser will still be able to use ...

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Abridged advice – for those with deferred benefits – take abridged advice rather than full advice.  Abridged advice only includes initial stages of advice process – there is fact finding but no APTA, or TVC

Addressing ongoing conflicts - advisers must prioritise a currently available defined contribution Workplace Pension Scheme (WPS) as a proposed destination for transferred funds. If a WPS is available but is not recommended the adviser must demonstrate why the scheme they recommend is more suitable

Initial charging disclosures – firms must send a ‘personalised charges’ communication to a client before providing advice – for abridged advice, full advice and ongoing advice

Suitability reports – enhanced disclosures – reports must include a one-page summary to include charges disclosure, adviser’s recommendation, statement on the risks of transferring, information about any ongoing advice service if transfer is proceeded with

Cashflow modelling – models must be prepared and presented to the client in real terms using reasonable assumptions for tax bands and limits allowing for taxes such as the LTA charge

Finalised guidance: Advising on pension transfers (FG21/3)

FCA issued a guidance consultation (GC20/10) and followed it with finalised guidance FG21/3: Advising on pension transfers in March 2021.

The aim is to improve the suitability of DB transfer advice and the individual consumer outcomes.

A TVC will involve which main assumptions?

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The Local Government Pension Scheme

The NHS Pension Scheme

The Teachers’ Pension Scheme

The Armed Forces Pension Scheme

The Civil Service Pension Scheme

The Police Pension Scheme

The Fire-fighters Pension Scheme

Public sector schemes have the following characteristics:

Pensions in payment are fully protected from inflation

Superior treatment to members on early retirement particularly if due to ill-health

Members of the Transfer Club

The Local Government Pension Scheme is funded whereas the other six schemes are not funded although the Teachers’ Pension Scheme and the NHS Pension Scheme are ‘notionally funded’.

Traditionally these schemes have offere...

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The result is that member’s benefits will be very similar to what they would have achieved had they always been in employment with the second employer based on actual past service.

Because public sector schemes moved to a CARE basis, schemes are now categorised as either ‘Inner’ or ‘Outer’ Club Schemes. The Transfer Club terms only apply where both the ceding and receiving schemes offer the same type of benefits, for example, where benefits on a CARE basis (Inner Club) are transferred to another scheme providing benefits on a CARE basis (Inner Club). Benefits can be transferred between Inner Club and Outer Clubs but the service credit applied is calculated on non-Club terms.

Explain how public sector schemes are financed.

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Estimated stud...

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