Pension Transfer DB Scemes Chp 3 Flashcards
What are the defined benefit Scheme features?
“Under DB schemes, the employer takes the investment risk. Employer and, if applicable, member contributions are set at a level determined by the actuary. They are then invested by the scheme trustees in order to meet the scheme’s ‘technical provisions’, i.e. the amount of assets required to cover the scheme’s future liabilities as they fall due.”
“An employee’s final salary DB pension will depend on whether they draw their pension at ’normal’ pension age, alongside the following three factors:
Pensionable service: this is usually the employee’s period of membership in the scheme.
Pensionable remuneration: this is the definition of earnings that is used to calculate the member’s benefits.
The accrual rate: the rules of the scheme will determine the rate at which benefits accrue, e.g. 1/60th of pensionable remuneration for each year of pensionable service.”
“Benefits in a career average scheme are calculated based on pension accrual on a year by year basis as follows:
each member accrues a proportion of their pensionable salary for each year of pensionable service e.g. 1/56th per year;
for active members of the scheme the amount accrued in each year will be based on the member’s salary for the year in question; and
each year’s accrual will then be revalued to retirement in line with the scheme rules; this could be in line with inflation (e.g. with increases in CPI) or by a fixed amount each year.”
“Another variation on a defined benefit scheme is the integrated scheme. With this type of DB scheme, the benefit provided at retirement age is reduced in some way to take into account the member’s Basic State Pension”
What is the difference between Flexible and Safeguarded benefits?
“Flexible benefits =
money purchase benefits, cash balance benefits and any benefit that is calculated by reference to a fund.”
“Safeguarded benefits =
benefits that are neither money purchase nor cash balance.”
What falls into the definition of safeguarded benefits according to the FCA?
“In Policy Statement 15/12 published in June 2015, the FCA confirmed that the following would fall within the definition of safeguarded benefits:
Policies with a guaranteed annuity rate (GAR). These are included because with GARs the benefits are calculated by reference to the guarantee and not just the plan value. The FCA, however, went on to add that in its view the factors to be considered in giving up a GAR are less complex than the range of benefits to be assessed under a defined benefit scheme and do not require a transfer value analysis.
The suitability assessment must, however, consider the value of the GAR that would be lost and the firm would still require the appropriate FCA permission.
Contracted-out DB schemes containing guaranteed minimum pension (GMP) are also regarded as containing safeguarded benefits as the DB scheme must guarantee to provide benefits at least equivalent to the GMP at the member’s State pension age.
Deferred annuities, also known as section 32 (S32) policies, that contain GMP are also safeguarded benefits. S32 policies are so named after the provision in s. 32 of the Finance Act 1981, which relates to deferred annuity contracts. They are known as deferred annuities as they will provide an annuity at some point in the future.
Who is eligible to join a DB Scheme and when?
“The rules of the scheme define who is eligible to join the scheme and when. Typical rules include the following:
a minimum entry age, e.g. 18 or 21;
a probationary or ‘waiting’ period before an employee may join the scheme – typically set up to one year, though it may be longer for those below a certain age;
differentiation between categories of employee, e.g. a scheme may differentiate between management, staff and workers; and
a different level of benefits offered to each category, e.g. more generous benefits are provided to the management category.
The employer cannot make membership of the scheme compulsory, although if the scheme is being used as a qualifying pension scheme, under the Pensions Act 2007, all eligible jobholders must be automatically enrolled into the scheme.”
What are the Employer contributions into a DB Scheme dependent on?
“the cost depends on several factors, such as the:
level of the members’ final pensionable remuneration in the future;
investment returns achieved by the underlying pension fund;
longevity assumptions within the pool of members and the associated costs of meeting the promised pension commitments – this is in effect similar to the way a life office calculates an annuity rate;
value of scheme assets, including member contributions paid;
cost of providing promised benefits to members who leave the scheme before the scheme’s normal pension age;
number of members who die before the scheme’s normal pension age;
and
profile of the scheme membership, e.g. the age and marital status of the members, which determines the period over which the contributions will be made and the level of spouse’s benefits that may need to be provided.
The employer usually contributes into the scheme on an annual basis. The scheme’s actuary will calculate the level of contribution required on a regular basis, which must be at least every three years. This is known as the funding rate.
What about the Employee contributions into a DB Scheme?
“As the costs of providing the promised level of benefits are unknown, most employers insist, as a condition of membership, that the employee pays a certain amount of these costs.”
Guaranteed Minimum Pension:
“Prior to 6 April 2016 the majority of DB schemes were contracted out. In a contracted-out scheme the member did not accrue any entitlement to Additional State Pension benefits, such as the State Earnings Related Pension Scheme (SERPS) or, since April 2002, the State Second Pension (S2P) for their period of pensionable service. Instead the scheme had to provide a certain minimum level of benefits to replace the Additional State Pension benefits given up. Members who were contracted out between 6 April 1978 and 5 April 1997 built up an entitlement to a guaranteed minimum pension (GMP), which was broadly the same amount as the pension they would have earned under SERPS. Contracting-out was not possible prior to the introduction of SERPS on 6 April 1978.
Contracting-out was abolished from 6 April 2016, but those who were members of a defined benefit scheme for any period between 6 April 1978 and 5 April 1997 will still have some GMP entitlement within the scheme.”
GMP where Member reaches State Pension Age before 6 April 2016
“Statutory escalation requires schemes to pay increases to GMP in payment of:
Pre-88 GMP – the scheme does not have to provide any escalation.
Post-88 GMP – the scheme is responsible for paying increases to the GMP in line with increases in the CPI to a maximum of 3% p.a..
Where the member is in receipt of benefits from a GMP they will receive additional payments from the State to make up the difference between the increases that the scheme is required by law to pay on the GMP and the rate of increase in CPI.”
GMP where Member reaches SPA after 6th April 2016
“These members are entitled to the new State Pension. Those who had not reached their SPA by this date will have had a starting amount – known as a foundation amount – calculated. This will ensure the individual is not disadvantaged by the new rules. Where the individual was contracted out before 6April2016, a deduction, called the rebate-derived amount, will have been applied to the new valuation”
“once their new State Pension comes into payment it will increase each year without reference to how much GMP they are receiving. In other words, unlike the pre-April 2016 rules, no ongoing allowance will be made to account for any CPI increases paid by the scheme in respect of post-88 GMP.”
“Guaranteed minimum pensions will lose value under the new State Pension rules, however those with longer to go to SPA will build up higher amounts of State Pensions under the new rules. The impact of these reforms will be worse for individuals who, having spent long periods in contracted out pension schemes, are now close to retirement. This is because they will not have the opportunity to build up additional entitlement to the new State Pension to compensate for the loss of increase to GMP accrued”
Statutory increases to Pensions in Payment to individuals attaining SPA before April 2016.
“The following table summarises the statutory minimum increases for individuals attaining SPA before April 2016.
Pre-1988 GMP*
The scheme does not have to provide any escalation. The State is responsible for paying the increases to the GMP in payment and will pay it along with the member’s other State Pensions.
GMP accrued between
1988 and 1997*
The scheme is responsible for paying increases to the GMP in line with increases in the CPI to a maximum of 3% p.a. Where CPI exceeds 3% in any year the additional escalation up to full CPI escalation is paid by the State.
Non-GMP accrual prior to
6 April 1997
No requirement for any statutory increases.
Pension for service after
5 April 1997 but before
6 April 2005
Must escalate in payment in line with CPI to a maximum of 5% p.a. (known as limited price indexation (LPI)).
Pension for service after
5 April 2005
Must escalate in payment in line with CPI to a maximum of 2.5% p.a.”
“Prior to 2011, statutory increases were based on inflation as measured by RPI and this was changed by the then Government to the CPI from 2011 onwards. However, some schemes still use RPI to calculate increases to pensions in payment rather than CPI.”
Statutory increases to pensions in payment to individuals reaching SPA after April 2016.
“Pre-1988 GMP
The scheme does not have to provide any escalation.
GMP accrued between
1988 and 1997
The scheme is responsible for paying increases to the GMP in line with increases in the CPI to a maximum of 3% p.a. The State does not have to provide any escalation.
Non-GMP accrual prior to
6 April 1997
No requirement for any statutory increases. The State does not have to provide any escalation.
Pension for service after
5 April 1997 but before
6 April 2005
Must escalate in payment in line with CPI to a maximum of 5% p.a. (known as limited price indexation (LPI)).
Pension for service after
5 April 2005
Must escalate in payment in line with CPI to a maximum of 2.5% p.a.”
“You should note that in the second table there is no longer any reference to GMP escalating fully in line with CPI. This is because for individuals who reach their SPA on or after 6 April 2016, there is no longer any increase made via the State Pension to reflect CPI increases on any GMP that the member may have. The only increases in payment to GMP for these individuals will be in respect of post-88 GMP where the scheme pays CPI increases up to a maximum of 3%. Otherwise, GMP will be paid on a level basis. Of course, the new State Pension that the individual receives will be index-linked.”
PCLS:
“Some schemes accrue the pension and PCLS separately, (known as ‘in addition’), e.g. the member may be entitled to 1/80th final pensionable remuneration for each year of service as a pension plus 3/80ths of final pensionable remuneration as a PCLS.
However, it is now more usual in DB schemes for the pension to be commuted to provide the PCLS, as follows:
the annual pension is reduced (commuted) on a pre-determined basis for every £1 of PCLS that is taken; and
the rules of the scheme will specify the commutation factor that will be used to reduce the pension, e.g. a commutation factor of 12:1 means that for every £12 of PCLS the pension will be reduced by £1.
Scheme commutation factors rarely reflect the full market value of the pension foregone. Research shows that there has been an increase in commutation factors, with the typical figure now being 15:1, although there are wide variances. However, for a member aged 65, a commutation factor based on market RPI annuity rates would be around 31:1. On these figures, in purely actuarial terms, higher rate, additional rate and basic rate taxpayers all lose out by drawing cash.
Excerpt From: Neil Dickey BSc (Hons) Chartered Financial Planner FPFS. “AF7: 2018-19 Study text.” The Chartered Insurance Institute, 2018-07. iBooks.
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PCLS contd. :
“A scheme that was contracted out prior to 6 April 2016, cannot allow any part of any GMP to be exchanged for PCLS”
“Under the simplified regime, the maximum PCLS is calculated as follows:
PCLS = (PCLS + (20 × residual pension)) × 25%.
The residual pension = pre-commutation pension – (PCLS/C), where C is the commutation factor used by the scheme.
This leads to a complex scenario because it is not possible to calculate the member’s residual pension until the PCLS has been calculated – and it is not possible to calculate the PCLS until the residual pension has been calculated.
The Pensions Tax Manual (PTM) lays out a formula that must be used to calculate the maximum PCLS payable by a DB scheme.
This formula is:”
Bridging Pensions:
“
Some defined benefit schemes pay a bridging pension, usually where the scheme’s normal pension age is lower than State pension age (SPA). When the member reaches their normal pension age a higher pension is paid until SPA is reached, at which time it reduces to reflect the commencement of the member’s State Pension. The effect of the reduction could be to reduce the scheme pension back to its normal level or to a lower level to compensate for the period of time that it was paid at a higher level, with the approach taken depending on the scheme rules. This can also be referred to as a State pension deduction.
Be aware
Not all schemes will reduce the pension after SPA if a bridging pension is in place prior to the SPA.
This is permitted under the Finance Act 2004 and the Finance Act 2013,”
Early retirement DB Scheme:
“James is a member of his company’s DB pension scheme, which provides a pension of 1/60th of final pensionable remuneration for each year of service. James is about to take early retirement on his 62nd birthday after completing 25 years’ service in the scheme. The scheme’s normal pension age is 65. James’ final pensionable remuneration will be £30,000 and the scheme applies an early retirement factor of 0.5% for each month that the member retires before the scheme’s normal pension age.
We can calculate James’ early retirement pension as follows:
James has accrued a pension of 25/60ths × £30,000 = £12,500.
James is retiring three years early, so the early retirement factor will be 3 × 12 × 0.5% = 18%.
His pension will therefore be reduced by 18% × £12,500 = £2,250 p.a.
His early retirement pension will therefore be £12,500 less £2,250 = £10,250 p.a.”
