Pensions: defined benefit schemes v defined contribution schemes

In contemplation of any family law proceedings, it is important to consider how payments are made, or will in future be made, under any pension scheme that either party may hold.

The way that a party’s retirement benefit interest is held by a pension fund, and upon maturity is paid down to the qualifying individual, is applicable to the orders that the Court may make for the division of the retirement benefit in financial proceedings.

There are two types of pension schemes: defined benefit schemes (often referred to as final salary schemes) and defined contribution schemes.

Defined benefit

A defined benefit pension scheme (often referred to as a final salary pension scheme) is a scheme that makes monthly or annual payments of income based on how much an individual earns upon retirement. In the event that the individual who has accrued an interest in the defined benefit scheme dies, there is often a provision in the pension trust deed and rules that provides that reduced payments are made for the benefit of a spouse or dependant.

Unlike defined contribution pensions (explained below), the amount that an individual will receive at retirement is of a guaranteed, pre-agreed amount, and will be paid directly to the individual. An annuity will not be purchased by the individual, as an income stream is provided directly from the pension scheme. An individual’s interest under a defined benefit scheme is in the income of the scheme as opposed to any capital sum accrued within the fund.

There are two sub-types of defined benefit schemes: final salary schemes (based on how much is paid into the pension fund by an individual prior to retirement) and career average schemes (based on the individual’s average salary across their career with the employer).

Defined benefit schemes are often the most valuable schemes that an individual can hold, due to the large salaries that can be awarded after working for substantial periods with one employer. Other benefits of final salary pension schemes can include:

• payment of a full pension if an individual has to retire early through ill health
• death in service payments to spouses, partners or dependants if an individual dies before reaching pensionable age
• reduced pension payments if an individual retires early.

Defined contribution

A defined contribution (often referred to as a money purchase scheme) pension scheme is a type of workplace pension. A defined contribution scheme is accrued by the contributions an individual makes to the scheme, contributions made by the individual’s employer to the scheme and tax relief that may be obtained from the Government. The majority of company pension schemes are now defined contribution schemes.

The contributions will be invested in the stock market with the aim of the accrued funds growing in value prior to the individual’s retirement.

There are two sub-types of defined contribution schemes – trust-based schemes (managed by a board of trustees who manage the pension fund) and contract-based schemes (where an employer specifically appoints a pension provider to run the pension scheme for their company – often referred to as a group personal pension).

The sum accumulated under a defined contribution scheme is used to secure a pension income through buying a financial product called an annuity, which is designed to provide a guaranteed income for the rest of the individual’s life, or to allow the individual to enter into income drawdown.

The quantum of income provided by a defined contribution scheme is dependent on the funds accrued in the pension pot, the type of annuity purchased, and the rate provided by the annuity provider.

Lump sum payments

You or your partner may have chosen to receive (commute) a payment from your pension schemes of up to 25 percent of your pension savings free of tax. This payment is often called a lump sum. Receiving a lump sum payment will reduce the amount of income received from your pension in future.

It is important, when considering you and your partner’s assets, whether a lump sum has been paid, whether you are entitled to receive a lump sum under any pension provisions, and where the funds from any lump sum payment have been utilised.