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18th September 2017
In this article, we look at the alternative pension arrangement - defined contribution pensions, also known as money purchase schemes.
Due to their inherent cost, considerably fewer DB schemes operate today than previously and following the introduction of Auto Enrolment in 2012, more and more people are now accumulating defined contribution type pension savings through a workplace pension, often funded or partially funded by their employer.
Defined Contribution (DC) pensions have been in existence for a long time and both individuals and their employer can make contributions. At retirement, the amount that the individual will receive is dependent upon the underlying fund value, which is directly influenced by how much is paid into the pot, investment returns (which vary) and after deducting any charges.
DB schemes are largely funded by the employer and they promise to pay a pre-determined retirement income based upon a staff member’s salary, the number of years they have been a scheme member and the accrual rate of the scheme (often expressed as a fraction such as 1/60th or 1/80th). Under DB schemes the trustees must continually ensure that sufficient assets are available to meet the future obligations of the scheme, namely; the pensions promised for the lifetime of the scheme members and frequently for spouses/civil partners beyond that. Most schemes also escalate in line with inflation which means that funding must be maintained to support this.
Employer funded DC schemes do not bear this growing liability as they provide no guaranteed income at retirement. The only certainty is how much goes in (and this is subject to limits), so the future pot is dependent upon contributions and investment growth, which means the underlying investment choices are very important.
In terms of benefits at retirement, DC pensions are generally considered to be inferior to DB arrangements because the benefits from a DB scheme are guaranteed and generally keep pace with inflation, but this isn’t really a fair comparison. For an employer, a DC scheme has nowhere near the same level of running costs and the employee has much more flexibility over how and when benefits can be taken.
Since April 2015 those with DC pensions have been able to effectively define their own income levels and frequency of payments and are able to access their pension fund (subject to minimum pension ages) in any method they choose. DB scheme members are restricted by the scheme rules and are not able to flexibly access benefits at all. This has led to some DB scheme members seeking a transfer to DC to allow them this increased flexibility, but such a move requires very careful consideration and expert advice.
The future value of a DC pension is the primary determining factor as to how long (or not) it will last and the larger the pension fund the more choices will be available. Of course, the level of withdrawal will influence how long the fund lasts.
If you live to be 100 years old and begin taking your pension at age 65 then a DC pension will need to continue to generate income for 35 years, so managing how much is taken each year becomes challenging and requires careful planning to avoid it running out too soon. This is when most people choose to seek financial advice from a regulated financial adviser such as ourselves.
Armstrong Watson Financial Planning is an independent financial advisory firm and offers advice to both individuals and businesses on pensions and retirement planning needs. To discuss your requirements, contact our Financial Planning Consultants at any of our office locations across the North of England and South Scotland.
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