Updated: Nov 21, 2022
There’s a lot of choice around pensions today and navigating your financial options can be confusing.
The differences, for example, between defined benefit and money purchase schemes are important and you must understand both if you are to make the best choice.
So, what’s the difference between a money purchase and a defined benefit scheme?
A money purchase, or defined contribution scheme, has become the most common type of pension scheme available. It covers a wide range of different pension plans, some of which are provided by employers (employer-sponsored schemes), while others are personal (or individual) schemes.
A money purchase scheme provides benefits on retirement based on the amount of money that has been paid into the scheme, how long this money has been invested, the level of charges and investment returns over this period.
Defined benefit schemes are typically pensions where the amount you will be paid on retirement is based on how many years you’ve worked for your employer and the salary you’ve earned.
How is your pension calculated?
Your pension income is usually calculated as follows: years in scheme, divided by accrual rate, multiplied by pensionable earnings.
For example, if your scheme has an accrual rate of 1/60th, and you were in a defined benefit pension scheme for 10 years, and retired at 65 on a salary of £24,000 a year, this would give you a pension of: 10 (years) multiplied by £24,000 (salary) divided by 60 (accrual rate) = £4,000 a year.
There is usually an option to give up some of the income due and receive a tax free lump sum instead. You would receive a guaranteed, rising, secure income for the rest of your life, no matter how long. On the other hand, if you do not enjoy a long life, the amount of money extracted from this type of scheme may be limited.
Most defined benefit schemes have a retirement age of 65, however you might be able to take your pension from the age of 55, but this can reduce the amount you get.
A Reeves Case Study
One Reeves client, Kevin, aged 57, wanted to retire at the age of 60. Over the years, he had acquired four defined contribution schemes and two defined benefit schemes but was unsure whether his retirement target date was possible.
The client decided not to obtain any advice on his defined benefit scheme (Reeves refer to a third party in such cases where clients do seek to obtain defined benefit advice). He preferred the secured income which they would provide, as these, together with his state pension would ensure a minimum standard of security in old age. He intended to use the flexibility provided by his investment based schemes to bridge the gap between retirement at 60, and the state pension being payable at 67.
So, we brought together his historic schemes into his current workplace scheme, simplifying his arrangements. We then put in place a more robust investment strategy, preparing for drawdown from the age of 60.
Generally, workplace schemes are relatively inflexible, however on this occasion, Reeves was able to take over the servicing of his AEGON ARC workplace pension and provide solid ongoing advice on the investments in it using the 4,000 funds available to us. Using this scheme, which already had a third of his personal pension provision in it, also meant that the initial fee payable to us was reduced by a third as Reeves does not charge for taking over management of funds in an existing scheme.
We always weigh the performance and risk of existing pensions against anything that we propose. When the performance of Kevin’s investment was analysed, the proposed Reeves investment portfolio was found to have performed significantly better than all of the underlying pension funds, which Kevin had not been focusing on previously.
This is common, as at Reeves we spend a great deal of time selecting high quality funds to include in our portfolios which have an excellent chance of delivering superior outcomes.
Kevin now has a transparent pension position, with a clear investment strategy, and has a retirement goal which we have confirmed is viable and we are now all driving towards together.
The articles are for information only and should not be construed as advice or a recommendation. The investment strategies mentioned are examples only and may not be suitable for your particular: circumstances, tax position or objectives. Please seek independent financial advice before taking any action.
Reeves are not authorised to give advice on defined benefit schemes. Should you wish to obtain advice in this area we will refer you to a third party.
Names have been changed to protect identity.
No advice should be conferred from the articles. No action should be taken without independent professional financial advice as any actions on your pension may be irrevocable and have a big impact on your income in retirement.