Workplace pensions are an important part of your pay package as they are deferred pay. However they are also the part that is often the least understood.
Studies have shown that a lack of understanding contributes to poor decision-making when it comes to pensions, so here are some pension basics.
What does defined benefit (DB) mean?
Here, the amount you’re paid is based on how many years you’ve worked for your employer, the salary you’ve earned and a pre-agreed accrual rate (this is a fraction of your salary, historically a 1/60 or 1/80, that is multiplied by the number of years you worked to determine your pension). This type of pension pays out a secure income for life, which increases annually in line with inflation.
Two types of defined benefit pensions
Final salary
A final salary scheme uses the accrual rate and your final salary before you retire to determine your retirement pension income.
Career Average Revaluated Earnings (CARE)
This uses the accrual rate against your salary in each tax year you work to determine the amount you will be paid in retirement. The pension accrued in each tax year is re-evaluated annually in line with inflation.
For more detailed explanations of pension types, visit the Money and Pensions Service website.
Risk
Defined benefit schemes are commonly referred to as ‘gold-plated’ pensions. This is because they provide a guaranteed, index linked income in retirement.
That guarantee means that the risk with this type of pensions lies with the sponsoring employer. Should the employer and employee contributions invested not meet the expected returns, the employer has to make up the shortfall.
Not only that, if the benefits paid out by this type of pension are higher than expected (due to increasing life expectancy for example), the extra funding also has to come from the employer.
As a result, many defined benefit schemes are in deficit and have recovery plans in place for sponsoring employers to make up the shortfall in the scheme.
If an employer becomes insolvent and has a shortfall in the funding of the pension scheme, the Pension Protection Fund provides a safety net.
Get help
If you have further questions about this contact us for more help.