Understanding Defined Benefit and Defined Contribution Pensions
In our weekly series, readers can email in with any questions about retirement and pension savings to be answered by our expert, Rachel Vahey, head of public policy at investment platform AJ Bell. There is nothing she does not know about pensions. If you have a question for her, email us at money@.
The Question: Transferring a Defined Benefit Pension
A reader asked: "I am thinking of transferring my defined benefit pension to a defined contribution pension where I can draw money down as and when I want. What do I need to think about? What are the pros and cons?"
What Are Defined Benefit Pensions?
Defined benefit pensions, often referred to as gold-plated pension schemes, were once the standard workplace pension. However, rising costs mean very few private sector schemes are still open, while public sector workers are more likely to still have access to them.
These pensions are valuable because they promise a pension income for life based on your salary and how long you were in the scheme. For example, you might build up 1/60th of your salary for each year you’ve been in the defined benefit scheme. Traditionally, the schemes used your final salary – they are often known as final-salary pensions – but now it’s more likely to be your average pay over your career. Some schemes also offer a separate cash lump sum, others will let you exchange part of your pension for a tax-free lump sum.
How Do Defined Contribution Pensions Differ?
In contrast, a defined contribution plan builds up a pot of money that can then be turned into an income at retirement, leaving employees with a much more uncertain outlook.
Most public sector employees are only allowed to transfer their pension to another public sector scheme, and not to a private sector scheme. The main exception is those who worked in local government. Private sector employees can, in theory, transfer their pension to a private sector scheme, for example a SIPP. However, in practice, this can be tricky.
Rules and Considerations for Transferring
There are strict rules for transferring defined benefit pensions. If the value of your defined benefit scheme is £30,000 or more, you must get advice from a regulated financial adviser. The adviser doesn’t have to recommend that you transfer, but in practice, unless you get that positive recommendation, many private pensions won’t accept the transfer.
The regulator – the Financial Conduct Authority (FCA) – says an adviser’s starting point should be that it’s not in the best interests of the member to transfer. So, you can see that there must be a strong case for an adviser to recommend transferring, and for most people this is unlikely. For this reason, it can be difficult to find advisers working in this area.
Pros and Cons of Transferring
If you transfer, you will be giving up a secure income in retirement – income you know you will receive each year, which will increase in value and help offset the effects of inflation. When you die, the pension will usually continue at a lower level to your spouse or partner if you have one.
For some people, a transfer may feel like a better fit for their needs. They might want more flexibility over how they take money from their pension, for example starting with a lower income and increasing it later. Others may be in poor health with a shorter life expectancy, and worry they won’t get full value from a scheme that pays a set income for life. This can be a bigger concern if they do not have a spouse or partner who would continue to receive payments after their death.
A transfer may also look more appealing if the pension is relatively small, particularly for someone who already has other substantial pensions, and wants more freedom over how they use that money.
Making an Informed Decision
There is much to weigh up in this decision. It’s best to take your time to think things through and get personalised advice on your options. Whether you choose to transfer or stay with your defined benefit pension, understanding the implications is crucial for securing a stable financial future.
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