Section 12 - Defined Benefit

DB scheme with DC underpin

Effectively have 2 calculations running at once

At retirement you get the higher of:

• DB value

• DC (Notional) value

Notional means it’s not a real pot - Just a calculation

DC scheme with DB underpin

The main pension is the DC (real pot) but there’s a guaranteed DB style benefit

DB part is like a safety net

Defined Cash

An Old school set up where pension gives a defined lump sum (Not flexible)

Limits how much TFC can be taken

Career average (CARE) schemes

Pension based on your average salary over your career (Not final)

Cheaper for employer

Less than final

Integrated schemes

DB pension is adjusted because of the state Pension

So at SPA, pension is reduced

Example:

Before SPA = £15k/yr

After SPA = £12k/yr

Contributing Pre & Post A-day

Pre top ups:

• AVCs

• FAVCs

Post top ups:

• AVCs

• Other Pensions

A-Day simplified topping up

In House AVCs

Extra contribution alongside your DB scheme

These go into a separate DC pot

• Employer may subsidise costs (cheaper than external pensions)

These AVCs can be used as 25% TFC instead of reducing DB

AVCs on added years basis

Instead of building a DC pot your contributions buy extra years of service

I.e.

Normal service = 20 yrs

Buy added 5 yrs

Pension now calculated as if they’ve worked 25 yrs

Means a bigger DB pension

DB rules

• Run by trust (the run pension not company)

• At NPA don’t have to retire to get benefits

• If NPA is before SPA = higher initial benefits

• DB income taxed via PAYE (earned income)

What does contracting out mean

Left part of the state pension in return for a better workplace pension (SERPS/S2P)

• Pay lower NI

• Now abolished (2016)

these must offer a GMP if worked between ‘78 and ‘97 (can’t get TFC with a GMP)

Pension Increase Exchange (PIE)

It’s an offer which says give up future inflation increases for a higher starting pension now

Good if you don’t live long + inflation is low

It’s an incentive exercise (firms trying to reduce liabilities)

Commutation

In DB schemes you don’t have a pot meaning no TFC

To get TFC have to give up some income (commutation)

Max you can take is 25%

Commutation example (commutation factor of 12)

means for every £1 of pension you give up you get £12 TFC

• Give up £1,000 pension & get back £12,000 TFC

Commutation valuation - Standard Rule

As there’s no pot use this to estimate

20 x annual pension

I.e.

Pension = £10,000

Value = £200,000 (20x£10,000)

Max PCLS = £50,000 (25%)

Pension reduction formula

If you take more cash your pension must reduce

New pension = old pension - (PCLS/Commutation.factor)

Maximum PCLS calculation

PCLS = 20 x pension x C / 20 + (3 + C)

C = comm factor

Rarely asked to calculate full

Early retirement

Benefits reduced by early retirement factor (Not 2.5%)

Depends on:

• Actuarial calculations

• Scheme rules

PCLS also reduced similarly

PCLS on DB schemes

Non Commutation

Some schemes have PCLS built in

• Pension + Automatic Lump Sum

Commutation

Give up income for TFC

Death In Service

Get paid a lump sum (multiple of salary)

Ongoing income for partner (50% of pension or % of salary)

Death before 75

• TF

• If exceeds LSDBA = taxed

Death after retirement

Spouse gets pension (50%)

Guarantee period

• If you die early remaining payment still made

Separate life insurance DIS

Used so early death doesn’t drain DB scheme

How DB schemes check to see if they have enough money (Actuarial Valuation)

• a detailed check of assets/liabilities

• Statutory Funding Objective - Scheme must have enough assets to meet promises

If underfunded

• Must have recovery plan

How DB schemes check to see if they have enough money (IAS 19)

This is the company accounts view

Shows surplus/deficit on balance sheet

Uses:

• Market Values

• Bond Yields

More volatile than actuarial valuation

How DB schemes check to see if they have enough money (Insolvency Valuation)

Used if employer is going bust

Calculates ‘how much it would cost to secure all benefits with an insurer’

How DB schemes check to see if they have enough money (PPF Valuation)

Used to decide if scheme can enter pension protection fund (PPF)

Scheme deficit

When liabilities > assets

Trustees must create recovery plan and send to TPR

Ways to fix:

• Increase money in (Higher Conts)

• Reduce future benefits

• Change investments

If changes are significant must hold consultation with employee

Employer’s Covenant

Employers ability and obligation to fund the pension

Legal obligation

Trustees care as:

• If employer is strong = more flexible recovery plan

• If employer is weak = higher risk

Funding and investment strategy (FIS)

A plan agreed between trustees & employer

Must include:

• Target funding level

• How to get there

• Investment strategy

Who can be a trustee for a DB scheme

For running the pension in members best interests

Who cant be one:

• Not a minor

• Mentally incapable

• Disqualified

What must trustees know

Must understand:

• Trust Deed - Rules of scheme

• Investment Principles - How money is invested

• Funding Principles - How scheme is funded

Trustee responsibilities

• To hold and invest assets

• Act in members best interests

• Report issues

Trustee specific duties

Financial control

• Auditing accounts

Reporting

• If conts are late - Report to TPR

Planning

• conts schedule

• Funding plan

• Recovery plan

Member nominated trustees

A 1/3 of trustees are member nominated

Exceptions:

• Scheme has 1 member

• Scheme is small insured scheme

• Every member of scheme is trustee

Leaving a scheme (Early)

Refund - short service (Less than 2 yrs)

• Get back own contributions

• Not guaranteed

Tax:

First £20,000 = 20%

Above £20,000 = 50%

If leave after 3 months - must be offered CETV

CETV (Cash Equivalent Transfer Value)

Value of your pension can be transferred to another scheme

Must be offered if worked longer than 3 months

Value must equal to guaranteed benefits

Enhanced CETV

Deferred members are offered enhanced TV’s

To reduce:

• Liabilities

• Future Risk

Leaving a scheme (longer service)

Preserved Pension - longer than 2 yrs

Your pension stays in scheme and paid later at retirement

Called a deferred member/deferred pension

Revalued each year for inflation

Types of Benefits (DB & DC)

Flexible benefits (DC)

• Based on pot of money

• Easy to transfer

Safeguarded benefits (DB)

• Guaranteed income

• More valuable = more protection

Transferring DB scheme

If more than 1 year from NRA

• have statutory right to transfer

If less than 1 year

• Trustees must agree

DC pensions can be transferred anytime

Transferring safeguarded benefits

If DB is more than £30,000 must get:

• Independent Advice

• From a pension transfer specialist

Trustees must see proof of this

What must advisers produce for DB member getting advice over transfer

Since 2018 advisers must produce:

• APTA (Appropriate Pension Transfer Analysis)

• TVC (Transfer value comparator)

To see if transfer is worth it

APTA (Appropriate Pension Transfer)

Process advisers must do when recommending DB to DC transfer

Just compares each scheme

TVC (Transfer Value Comparator)

it compares the transfer value offered vs what it would cost to replace DB benefits

Replacement cost

• How much money you’d need today to buy an annuity to match DB income

Cost to buy = £250,000

CETV = £180,000

= Shortfall

Critical yield

What investment return you need to match your DB benefits

If required return is high = risky

Standard assumptions advisers must use in APTA/TVC so everything is consistent

AIR (Annuity Interest Rate)

• The discount rate used to value future pension income

Inflation

AEI (Average Earnings Index)

• Assumed at 3.5%

• Used for salary growth

Annuity Expense Allowance

• Cost of setting up annuity

Product Charge

• Cost of investing in DC if transferred