Let’s take a fairly detailed look at UK-defined benefit pensions.
I get a lot of questions about these, especially from clients who want to use their UK workplace pension to help them retire in Australia.
What is a Defined Benefit (DB) pension?
A defined benefit pension scheme is a type of workplace pension scheme (so, different from your state pension). Unlike the majority of workplace pensions, which are now ‘defined contribution/money purchase’ pensions, the amount you receive when you retire doesn’t depend on the amount you have paid in and how well that money performed when invested. The sponsor of the scheme (the employer) bears the investment risk associated with defined benefit pensions.
With a DB pension, your retirement income is determined by your accrual, i.e. the rate at which pension benefit is built up as pensionable service in a defined benefit scheme. Often expressed as a fraction or percentage of pensionable salary, e.g. 1/60th (or 1.67 percent) for each year of service. For a long time, defined benefit pensions were known as ‘final salary pensions’ and now, the terms are often used interchangeably.
How does a defined benefit pension work?
A defined benefit pension works, as the name suggests, to give you a defined and guaranteed income in retirement. It’s an income that’s index-linked, designed to keep pace with UK inflation.
Your employer contributes towards the scheme, and in some cases employees also contribute, but you are not reliant on the fund’s performance, unlike a defined contribution pension.
If you have a DB pension, when you retire you can access pension commencement lump sum (PCLS) from your retirement savings which is free of UK tax, though is treated as assessable income for Australian residents The value of PCLS available will vary from scheme to scheme, with a commutation factor applied with a typical factor of 15, i.e. you give up £1,000 of annual income for every £15,000 taken as a lump sum. Many people (both members and Australian advisers I speak with) are confused about this, so it’s helpful to know if you plan on spending your retirement in Australia as your PCLS, sometimes referred to as your tax-free lump sum, is typically treated as assessable for tax in Australia.
Note that, unlike defined contribution schemes, accessing a defined benefit pension prior to the scheme’s normal retirement age (NRA), usually 60 or 65, can result in a reduced annual income – known as an early retirement factor. This is to take into account the extended period of time the pension will be paid for. Not all defined benefit schemes will allow early retirement and the earliest age you can access a UK pension is 55 years of age (rising to 57 from 2028).
How are defined benefit pension benefits taxed?
Pensions commencement lump sums are tax-free in the UK, however, Australian residents should note that PCLS payments are, in most cases, accessible for income tax in Australia.
Pension income: Defined benefit schemes in the UK operate in the same way as payroll, with income tax being withheld and paid to HMRC. Australia has taxing rights on permanent residents and citizens worldwide income. However there is a double tax treaty between the UK and Australia which deals with all income types, so any tax paid in the UK can be offset against Australian taxation on foreign-sourced income. It is possible to apply for a UK tax code that transfers the taxing rights to Australia, however there is no guarantee such tax codes can be obtained. Either way, income drawn from a UK pension by Australian residents will be taxable in Australia at your highest marginal rate of income tax in the relevant financial year.
Are defined benefit pensions rare?
Now they are. According to the pension protection funds annual publication the Purple Book, there were 5,327 defined benefit pension schemes in the UK as of 31st March 2020. Years ago they were more prevalent, but with ever-increasing life expectancy and lower investment returns experienced by pension schemes, they have become expensive for employers to fund. Many funds are now underfunded i.e. a shortfall in assets to cover anticipated liabilities in the form of pension payments.
However, many public sector workers, such as NHS staff, police officers, firefighters, and teachers are still offered defined benefit pensions. These pension schemes are unfunded, with the funding to cover annual pension payments coming from exchequer tax revenues. Since 2015, in most cases it is no longer possible to transfer unfunded schemes. Not all government pension funds are unfunded however. Local government pensions from local councils in the UK tend to be funded and are still transferable.
How much will I get from my defined benefit pension when I retire?
It will mainly depend on the terms of your individual scheme, but the leading factors that will impact the final figure you receive are:
- The number of years you worked for your employer
- Your salary when you stopped working (although some schemes take an average salary over your time served)
- Revaluation of your benefits: the amount of indexation applied since leaving your employer accrual rate, which will be the final factor. This is a fraction of your final salary and is normally 1/80 or 1/60. To work out your income, you take the accrual rate and multiply it by the number of years you worked for an employer (and were part of the scheme). Example: £60,000 final salary after working for 20 years with an accrual rate of 1/60 would mean 20/60 and an income of £20,000 indexed annually, usually in deferment and in payment. However, this is just a guide. There is no simple way to calculate the exact value of a defined benefit scheme without scheme specific information and the members records, which typically needs to be requested from the administrators of the scheme.
If you need a more accurate answer based on your individual circumstances, please don’t hesitate to get in touch.
What happens to my benefits when I die? Are my benefits passed on to my family?
Death pre-retirement: Defined benefit schemes usually offer lump-sum death benefits and scheme pensions to dependents. There are two main death benefits:
- Lump-sum death benefits, a lump sum in line with the scheme death benefit policies and;
- Scheme pension is usually based on a percentage of the member’s pension entitlement. The benefit is typically equal to 50% of your income entitlement, indexed in-line with the scheme rules.
Death benefits cannot be transferred into a pension belonging to the dependent as a lump sum and will in most cases cease upon the death of the dependent
Definition of dependent as broadly described by HMRC (UK tax authority) is:
- the member’s widow(er) or civil partner at the time of the member’s death
- a child of the member who is under 18 or under 23 in full-time education (scheme dependent)
- a child of the member who, in the opinion of the scheme administrator, is dependant on the member, because of physical or mental impairment, at the date of the member’s death
- a person who wasn’t married or in a civil partnership and is not a child of the member, who in the opinion of the scheme administrator is, at the date of the member’s death:
- financially dependent on the member
- in a financial relationship of mutual dependency with the member; or
- dependant on the member due to mental or physical impairment.
How are defined benefit pension death benefits taxed?
Defined benefit pension lump sum death benefits: This is a complex area beyond the scope of this article. For more information refer to HMRC pension tax manual. In summary, taxation is influenced by factors including the age of the member at death (up to and after the age of 75), and whether the member has crystallised their benefits.
Defined benefits scheme benefits/dependents scheme pension: Where a dependent receives a scheme pension, the dependent will be liable for income tax on the continuing pension payment at their own marginal rate of income tax. Where the beneficiaries tax code is unknown, emergency (month 1) rules will apply and the beneficiary will have to contact HMRC to assess any overpaid tax or to make a payment where tax has been underpaid.
Transferring dependent’s scheme pension: Transfer of dependent’s scheme pension after a benefit crystallisation event: Regulations provide for the transfer of sums/assets by registered pension schemes and insurance companies, where those sums/assets represent pensions in payment. A transfer of sums/assets from a dependent’s scheme pension between registered pension schemes is only treated as being a recognised transfer if those sums or assets are applied for the provision of a new dependent’s scheme pension. Where the dependent’s scheme pension is being paid by an insurance company, the amount transferred is treated as an unauthorised payment (55% tax charge) if a new dependent’s scheme pension is not provided.
Source: The Registered Pension Schemes (Transfer of Sums and Assets) Regulations 2006
Transferring your defined benefit pension
So, defined benefit pensions are pretty good, but there may be certain circumstances when you might want to move funds out of one. You may want to access income at 55 (rising to 57 from 2028) years old without an early reduction factor being applied, access a lump sum prior to the NRA, or move overseas to a country such as Australia and transfer your pension with you, where upon reaching preservation age (60 for most people) and a meeting a condition of release from the income drawn in retirement will not be subject to income tax, unlike income drawn from a UK pension as a tax resident in either Australia or the UK.
If your scheme is funded (most private sector defined benefit pensions are) and you can get a cash equivalent transfer value (CETV), then you can transfer to a defined contribution scheme such as a self-invested personal pension (SIPP).
You will however lose the ‘guaranteed’ income and your retirement funds will be subject to the performance and risks associated with investment decisions made within the scheme receiving the transfer too. In fact, if your defined benefit pension is valued at £30,000 or more, then you’ll need to speak to an independent financial adviser first, to make sure it’s the right decision.
Unfunded public sector defined benefit schemes can’t normally be transferred.
What about an enhanced transfer value (ETV)?
I mentioned that defined benefit schemes are expensive to employers. In recent years, many companies have attempted to manage or reduce their pension risk by providing Enhanced Transfer Values (ETVs). An ETV can often be many, many times higher than the annual income the schemes provide, so it’s definitely something worth seeking expert advice about if it’s offered to you by your employer.
What is the outlook for DB pensions going forward for Australian residents?
Soar in transfer requests: Requests to transfer defined benefits have soared in recent years, no doubt due in part to the introduction of pensions freedoms by the UK exchequer in 2015, which only applied to defined contribution/money purchase pensions. Pension freedoms removed income drawdown limits which were age-based, i.e. the younger you were the less income you could draw from defined contribution/money purchase pensions. Pension freedoms also allow access to these pensions from age 55 (rising to 57 from 2028), with the flexibility to access pension savings via a cash lump sum while continuing to work. The flexibilities introduced by pension freedoms, which did not apply to defined benefit pensions, attracted people to transfer their defined benefit pensions to more flexible defined contribution schemes to gain access to the newly introduced flexibilities, to meet their individual needs and circumstances.
Cash equivalent transfer values (CETV’s) have also soared to record highs due to the increased costs associated with replacing the guaranteed income from a defined benefit pension. The sums offered in return for irrevocably giving up the rights to the guaranteed income are, for many, viewed as life-changing . One of the major influences in the significant increase in transfer values has been the reduction in the UK 15 year gilt rate (government borrowing/treasury bonds), which in January of 2007 was 5.35% and as low as 0.339% in July of 2020, and 0.85% at the time of writing. The significance of this being that Bank of England gilts are considered a risk-free return, so the lower the rate, the higher the cost of replacing the guaranteed income of a defined benefit pension and the associated CETV. The inverse is also true; the higher the gilt rate, the lower the replacement cost and typically the CETV offered.
There are other variables such as the member’s proximity to retirement age, the mortality rates of the scheme and annuity rates. While we have seen a spike in gilt rates so far in 2021, partly in response to the concerns over inflation (which tends to lead to central banks increasing interest rates to bring inflation under control or within the range of targets), the question is, how long can interest rates remain at close to zero? It is conceivable that economical challenges in the UK as a consequence of Brexit, might force the UK exchequer to increase interest rates to attract foreign investment and strengthen the pound. At best we can only conclude the future impact of interest rates on the transfer values of UK defined benefit pensions is uncertain.
Regulation and availability of advice
Regulation focused on defined benefit pensions has seen more changes in the last 7 years than at any time in the past. The focus more recently has been on scrutiny of advice to members of these pensions by the Financial Conduct Authority (FCA), the UK regulator.
The FCA has probed firms multiple times over the past couple of years as part of its ongoing crackdown on unsuitable advice in the market.
In 2020 hundreds of firms quit the market following the FCA intervention, which warned that too many firms were still failing to collect the necessary information to provide advice. In 2019 almost 80 percent of advisers in the defined benefit market were probed about their transfer advice as part of the regulator’s crackdown, with the watchdog writing to more than half of the 2,500 advice firms in the sector expressing concerns.
Earlier this year, data from the FCA showed the number of active firms in the pension transfer market had declined from 2,426 firms in 2015-18, to 1,310 firms in 2018-20. But there were 103 (6 percent) new entrants to the market. Overall, the regulator said there were currently (June 2021) 1,521 firms with DB transfer advice permissions.
The City watchdog is expected to continue reviewing firms’ DB advice until at least spring 2022.
The FCA introduced a ban on contingent charging (the practice of only charging a fee where a transfer was recommended) on DB transfer advice in October 2020. Data from the FCA showed that 70% of clients advised on a contingent fee basis ended up transferring their defined benefit pensions, versus firms operating under a non-contingent fee (upfront fee regardless of the outcome of the advice) model with a 27.97% conversion rate. This clearly highlighted the potential for a conflict of interest where firms were only receiving a fee for recommending a transfer.
Professional indemnity insurance premiums for firms with DB pension transfer permissions have also soared in recent years, with one firm I know of seeing their annual premiums increase from £10,000 in 2017 to over £140,000 in 2021. These increases have no doubt resulted in many advisers having to exit the market due to unaffordable premiums. With a near 40% reduction in firms providing DB transfer advice in 4 years, the cost of FCA licensed advice has increased from £500-£750, to anywhere between £3,500 – £9,000.
Protecting consumers from unsuitable advice is of paramount importance both for consumers and confidence in the advice sector, though it’s clear the unintended consequences has undoubtedly been limiting the number of advisers with the necessary permissions to provide advice on DB pensions, as well as access to advice for many consumers who cannot afford, or are simply unwilling to pay for advice upfront regardless of the outcome of the advice.
If you currently hold a UK defined benefit pension and would like to know where you stand and what your best options are, please get in touch for some professional advice, tailored to your individual circumstances.
Jason O’Connell is an authorised representative (“AR”) of Shartru Wealth Management operating in Australia under AFSL: 422409.
Information on this website is general advice and does not take into account your objectives, financial situation or needs. You should consider whether the advice is suitable for you and your personal circumstances.