Pensions are a tax-efficient way to save up for retirement. A defined benefit pension plan, also known as a final salary pension, is a type of pension plan. Defined Benefit pensions tend to be more common in the public sector, although some private sector businesses do still offer them.
What is defined benefit?
A defined benefit pension is an arrangement where the employer promises to pay a specified amount of money to an employee upon retirement. This amount is determined by a predetermined formula that takes into account the employee’s salary history and years of service with the company. A secure income is paid for life upon retirement, which increases in line with inflation.
What are the advantages of a DB pension plan compared to defined contribution plans?
Defined benefit pension plans offer several advantages compared to defined contribution plans in the UK. These include:
- Predictability: The employee knows exactly how much they will receive in retirement.
- Employer responsibility: The employer is responsible for funding the plan and ensuring that there are sufficient funds to pay out the promised benefits.
- Inflation protection: Most offer inflation protection, which means that the employee’s pension payments will increase each year to keep pace with inflation.
- Long-term security: Defined benefit plans are designed to provide retirement income for the rest of the employee’s life.
How do companies fund their DB pension plans?
Companies fund their defined benefit pension plans in the UK in several ways.
Firstly, they may make regular contributions to the plan from their profits or cash reserves. These contributions are invested in a variety of assets such as stocks, bonds, and real estate, to grow the plan’s assets over time.
Secondly, companies may set up a separate pension fund or trust to manage the plan’s assets. The trustees of the fund may invest assets on behalf of the plan, to generate returns to pay for future pension payments.
Additionally, some companies may purchase annuities or other insurance products to provide a guaranteed stream of income to the plan if the plan’s assets are insufficient to meet its obligations.
Finally, some companies may also consider options to de-risk their pension plan, such as transferring liabilities to a specialist insurer.
What are the risks associated with defined benefit pension plans?
Some risks associated with defined benefit pension plans in the UK include:
- Longevity risk: This is the risk to the employer that pensioners will live longer than expected, thereby increasing the cost of the pension plan.
- Investment risk: Defined benefit plans are invested in a range of assets, such as stocks and bonds, so they are subject to market volatility. Poor investment returns can cause the value of the pension fund to decline, which is a risk for the employer.
- Funding risk: If the plan sponsor does not contribute enough money to the plan or has not invested the money appropriately, then the pension plan may become underfunded, which will cause problems for the employer.
- Insolvency risk: If the plan sponsor goes bankrupt, the defined benefit plan may also be at risk and pension obligations may not be fulfilled, affecting the employee.
The first three reasons are why defined benefit pensions are no longer offered.
What are the differences between a DB pension plan and a defined contribution pension plan?
The main difference between defined benefit pension plans and defined contribution pension plans relates to what you receive upon retirement. In a defined benefit pension scheme, your employer promises to pay you a set amount each year, based on your final salary or career average. In a defined contribution scheme, payments depend on how much was paid in, how well the investments performed, and how you choose to make the money from the pot.
What is the maximum amount of pension benefit that can be paid under a DB plan?
In the UK, the maximum amount of pension benefit that can be paid for the 2022/2023 tax year is £60,000. This cap is designed to limit the tax advantages that can be gained from high pension incomes.
