Defined Benefit Pensions – Legal Structure
Defined Benefit (DB) pension schemes (more commonly known as ‘Final Salary’ pensions) are set up as ‘trust’ based arrangements.
Usually, an employer ‘sponsors’ a pension plan which is set up as a trust arrangement. As such, pension contributions are made into the ‘trust.’
Trustees are appointed to look out for the beneficiaries, which is you if you’ve made contributions or had them made on your behalf.
This means ‘trustees’ are looking out for the members who will derive benefits from the DB scheme.
If you’re a member of a Defined Benefit pension scheme….that’s you!
Defined Benefit pensions have scheme rules that evolve as a joint effort by employers and trustees BUT the ultimate oversight of a scheme is the responsibility of the trustees.
Employers and trustees adhere to scheme funding principles included within a code of practice.
Defined Benefit Pensions – Making the Rules
DB Pension Scheme Rules
When devising scheme rules the sponsoring employer and trustees will define the following:
Eligibility to join the scheme – This may have been a ‘probationary’ period before being able to join the scheme.
There may also be different definitions of membership with corresponding levels of benefits.
The membership of a scheme will usually be the employment service with a maximum of 40 years.
Normal Retirement Age (NRA) –
This is the age you cease contributions to the scheme and begin to take benefits (unless these are taken earlier due to poor health.) If you left a scheme years ago your benefits are ‘preserved’ but the NRA will still apply.
Employer contributions –
It’s the responsibility of an appointed scheme actuary to calculate the level of contributions necessary from both members and sponsoring employer.
A review takes place every 3 years (funding rate time) but interim reviews are undertaken if there are concerns around the funding rate.
Pensionable remuneration –
Bonuses, commission and overtime may be included but most schemes just use basic salary.
Accrual rate –
This will specify the rate at which scheme benefits accrue for each year of service and importantly tells you the proportion of pension pay you will receive.
If changes have been made to the accrual rate during the period of operation of the scheme then members will have different levels of benefits.
This is a common tactic to help reduce liabilities and it is imperative that these are taken into account during a defined benefit pension transfer.
Defined Benefit Pensions – What Impacts Funding Rates
DB Pension Funding Rate
A Defined Benefit pension scheme will have a range of liabilities at future given points in time.
This requires calculations based on ‘tranches’ of retirees, calculations as to their life expectancies, and calculations which add in new members retiring.
The returns from investments and economic factors determine the funding rate necessary to fulfil obligations.
Other Factors Impacting the Funding Rate include:
- Annuity rates when a member retires (unless pension paid directly from the fund with no annuity purchased)
- Cost of guarantees to leavers prior to retirement
- Investment performance
- Changes to demographics including mortality rates
- Impacts of salary level changes
- Regulatory or legal changes
These are all very significant factors.
Defined Benefit Pensions – Contributions
A Defined Benefit pension scheme may be contributory on non-contributory.
If a scheme is contributory your employer will specify how much contributions will be.
It’s standard practice for a review to take place every 3 years but some DB schemes with large deficit positions may review more frequently (probably review several times a day!)
Employee contributions are made on a ‘net pay’ tax arrangement.
This means an employee receives tax relief straight away because their contribution is taken from their pay before tax is taken.
Additional Voluntary Contributions (AVCs)
AVCs allow individuals to ‘top up’ their pension if their scheme rules state they can.
By effectively ‘buying’ added years and on the basis of the expectation of salary increases in the near future employees can extend benefits payable when they retire.
In relation to a pension transfer, these are treated separately.
Defined Benefit Pensions – Statutory Increases
Defined Benefit pension schemes must make statutory increases to pension entitlements to keep up with inflation.
When an individual leaves a Defined Benefit pension scheme they will have built up ‘preserved benefits’.
These must be revalued and every effort must be made to ensure preserved benefits keep up with inflation.
But the responsibility of the scheme doesn’t end there.
Once an individual retires DB schemes also have a statutory requirement to increase benefits to keep up with inflation.
Defined Benefit Pensions – Statutory Funding
In order to meet statutory funding objectives Defined Benefit pension schemes need enough assets to cover their liabilities as they are due.
These are known as Technical Provisions.
A statement of ‘funding principles’ provides the policy for a scheme to achieve its funding objective.
Furthermore, an actuarial valuation is provided every 3 years but (as mentioned above) more frequent valuations can be made at any time if there are concerns that statutory funding objectives may not be met.
Have you checked your pension scheme’s funding rate lately?
The factors taken into account when making the valuation will include:
The demographics of the scheme
This will identify different groups of employees and potential liabilities at specific points in the future.
Analysis taking into account mortality trends which will feed into longevity risk (risk of being unable to pay pension) for the scheme.
These may be directly impacted by current investments and any illiquid assets.
An analysis of risk-based scenarios based on falling valuations (i.e. property) must also be factored in.
Defined Benefit pension schemes need to make assumptions about future investment returns.
They can then use these to determine how much, in terms of contributions, are needed today.
The discount rate is used to allocate the cost of future benefits over time.
The lower the discount rate used the higher the liabilities will seem and the higher the contributions will be necessary today.
Expected rates of return on asset classes
Evaluating data from a variety of sources that leads to assumptions around inflation rates, interest rates and yields on government bonds.
All of these factors are so important with the valuation, and often very subjective!
Defined Benefit Pensions – International Accounting Standard 19 (IAS19)
This international accounting standard really impacted how companies are allowed to present financial information relating to their pension liabilities.
The respective UK accounting body uses Financial Reporting Standard 17 (FR17).
One of the main drawbacks of using this accounting standard is the volatility pension deficits can cause to a company’s profit and loss account.
Ultimately, by reducing pension liabilities companies are able to improve the balance sheet.
Defined Benefit pension and Valuation against LTA