2 : 3 - The Key Characteristics of Defined Benefit (DB) Schemes

Question 1

What is the definition of a DB scheme?

Answer 1

Where members are promised specific benefits at a specific age according to the rules of the scheme.

Question 2

A DB scheme may change the level of employee contributions for new members and it may have to change the level of employer contributions as a result of:

(4)

Answer 2

• investment performance and its effect on scheme assets
• changes in the demographics of scheme members including mortality rates
• impacts of salary level changes
• regulatory or legal changes.

Question 3

What are the Member Benefits of DB Schemes?

Answer 3

• DB pensions are normally index-linked.
• Part of the pension taken at retirement can be as a tax-free lump sum.
• On death in service, the member’s beneficiaries receive a lump sum payment with a dependants’ pension also being paid.
• Should the member be unable to continue to work due to critical or chronic illness, early retirement with a significant proportion of pension benefits may be possible.
• Employer contributions to the member’s retirement pot are considerable.
• The purchase of extra pension credits may be possible.

Question 4

What are Career Average Revalued Earnings (CARE) Schemes?

Answer 4

These run in a similar way to defined benefit final salary schemes, but with differences in the way that your ‘pensionable earnings’ are calculated

Question 5

How is a CARE scheme typically run?

Answer 5

On behalf of the employer by the Board of Trustees, who are responsible for all aspects of the scheme. This includes paying out benefits to retired members. Daily management of the scheme is typically done by the Scheme Administrator, who reports to the Board of Trustees

Question 6

What does a CARE scheme typically offer?

Answer 6

An income in retirement based on a proportion of your average earnings, after adjusting these for inflation, during the whole period of membership of the scheme.

Question 7

What does a CARE scheme normally offer?

Answer 7

An income in retirement based on a proportion of your average earnings, after adjusting these for inflation, during the whole period of membership of the scheme.

Question 8

How is a CARE scheme fraction calculated?

Answer 8

As a member, you build up a fraction (the accrual rate) of your career average revalued earnings for each year of membership of the scheme.

Typically, this fraction may be 1/60th or 1/80th of your career average revalued earnings (for each year of scheme membership).

Question 9

What has caused the cost of running DB pension schemes to rise?

Answer 9

• members living longer
• falls in pension fund values
• loss of advance corporation tax (ACT) relief, which has indirectly reduced investment returns
• compliance with new and more stringent regulatory requirements for pension funds, such as the need to meet a minimum funding requirement.

Question 10

What can be used to top up occupational schemes?

Answer 10

AVCs

Question 11

What are the 2 methods of AVCs?

Answer 11

1. AVCs on an added-years basis

2. AVCs on a DC basis

Question 12

What are AVCs on an added-years basis?

Answer 12

where it is possible to use AVCs to buy added years of service in the scheme, the actuary for the scheme will calculate the cost of buying one added year of service.

The actuary is likely to be conservative when making assumptions to ensure the cost of providing the guaranteed benefits does not exceed the AVCs being paid plus investment growth.

Benefits are usually paid in line with the rules of the DB scheme and can normally only be taken at the same time as the main benefits from the scheme.

Question 13

What are AVCs on a DC basis?

Answer 13

The employer may have set up a scheme to receive AVCs or they may have a group personal pension arrangement in place.

The member’s AVC will be paid into a fund that is invested until retirement when it is then used to pay an additional pension for the member.

Question 14

Who are added-years AVCs best suited for?

Answer 14

An employee who is expecting their salary to increase quite quickly in the future.

Question 15

Do WPSs have to be set up as a trust?

Answer 15

No - most, however, are

Question 16

Why are WPSs set up as a trust?

Answer 16

By having a WPS set up as a trust, the assets within the scheme are protected for members and are not the assets of the employer.

Question 17

What are the areas that trustees are responsible for?

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Answer 17

1. Contributions
2. Payments to members and records kept
3. Investment fund
4. Professional advice
5. Registering and paying the levy
6. Reporting to TPR
7. The annual report
8. Trustees’ liability

Question 18

What is an area of concern over reporting?

Answer 18

That the credit ratings agencies have actually underestimated pension risk in debt-rating estimates as they did in the sub-prime mortgage scandal

Question 19

What has been a consequence of the introduction of FRS17?

Answer 19

A much greater emphasis on the investment approach taken by trustees and investment managers of DB schemes

Question 20

What is the result of this greater emphasis?

Answer 20

A move away from investing higher proportions in equity and property assets towards a liability-driven investment approach.

One alternative, that some schemes have adopted, is to outsource the entire pension fund to be managed by an insurance company – again, though, higher cost structures apply.

Question 21

What is a Pension Commencement Lump Sum (PCLS) ?

Answer 21

As well as an annual income, schemes can offer a separate lump sum or annual income can be commuted (reduced) for a lump sum.

Question 22

EG:

• Scheme A has an accrual rate of 3/80ths multiplied by the number of years’ service of final pensionable salary to calculate the lump sum.

Answer 22

• Scheme B has a commutation rate of 12:1 which means that for every £12 of Pension Commencement Lump Sum (PCLS) taken, the annual income will be reduced by £1.

Question 23

How does early (or late) retirement effect a scheme?

Answer 23

Most schemes allow the member to retire early. If they do then their benefits are calculated at the date of retirement and then reduced by an actuarial reduction factor.

Similarly, some schemes allow members to retire after the normal retirement age (NRA) and a late retirement enhancement factor will be applied to their pension, which would result in an increased pension being payable.

Question 24

How does ill health effect a scheme?

Answer 24

Scheme rules may allow ill health early retirement to those under 55. The scheme rules will state how benefits are calculated and it is common for early retirement reduction factors to be ignored or deducted.

Question 25

What death benefits are associated with WPSs?

Answer 25

Schemes can pay a lump sum to the members’ beneficiaries in the event of death in service. The lump sum would be free from tax with the exception of the lifetime allowance (LTA) tax charge of 55% for lump sums paid over the LTA.

Question 26

Does a spouse receive any death benefit?

Answer 26

In addition to any lump sum paid to those who die in service there is often a spouse’s/civil partner’s/ dependant’s pension paid too. The scheme rules will state how these benefits are also calculated and it is common for 50% of the members’ pension to be payable.

Question 27

What are the 3 options when leaving before NRA?

Answer 27

1. A refund of the member’s contributions - The refund of the member’s contributions will be taxed at 20% on the first £20,000 and 50% on the remainder.
2. Preserved benefits – normally available when there have been at least two years of service, the member would be entitled to a minimum level of benefits know as a ‘short service benefit’.
3. Cash equivalent transfer value (CETV) – this must be offered to anyone who has completed three months’ pensionable service. The member can transfer their pension away from the scheme into another pension.

Question 28

Before transferring a DB pension - At what value does the FCA require a member to received financial advice?

Answer 28

Before transferring a DB pension scheme worth over £30,000, they must consult a regulated pension transfer specialist.

Question 29

What is a TVAS for?

Answer 29

The TVAS calculates the annual investment return, known as the critical yield, required from a new pension arrangement to match the benefits available from a DB occupational pension scheme at the date of retirement, early retirement and/or late retirement.

Therefore, if the transfer value grows by the critical yield each year until retirement, it should provide a fund that matches the capitalised value of the DB scheme.

Question 30

What does the TVAS make assumptions about?

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Answer 30

• annuity rates
• inflation
• national average earnings
• revaluation rates
• mortality
• investment returns.

Question 31

Is the critical yield accurate?

Answer 31

The critical yield therefore is only going to be accurate if all the assumptions become a reality; however, the critical yield will help to put into context the fact that transferring from a DB pension to a DC arrangement moves the investment risk from the employer to the member.

Question 32

What dose a critical yield demonstrate?

Answer 32

If the member has a low attitude to risk and is very cautious when it comes to investing then a critical yield of 10%, for example, is likely to result in the advice being to stay in the scheme. Term to retirement is also an important factor as the longer the member has to invest then the more likely they will achieve a higher return from equity-based investments.

Question 33

What new (2017) rules did the FCA introduce to ensure transfer advice considers relevant factors?

Answer 33

• transfer advice should take the form of a personal recommendation that takes account of a consumer’s personal circumstances
• advisers should start from the assumption that a BD transfer will be unsuitable
• TVAS will be replaced with a personalised analysis of the consumer’s options and a comparison to show the value of the benefits given up. Instead of TVAS the adviser must perform an ‘appropriate person transfer analysis’ (APTA and a prescribed transfer value comparator (TVC) indicating the value of the benefits given up and the cost of purchasing the same income in a defined contribution (DC) environment.

Question 34

What sectors typically have public service schemes?

Answer 34

• civil servants
• the judiciary
• local government workers
• teachers
• health service workers
• fire and rescue workers
• members of police forces
• members of the armed forces.

Question 35

Are members of unfunded public sector schemes (such as the NHS, teachers and civil service schemes) able to transfer their benefits to access the new flexible benefits?

Answer 35

No