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Defined contribution vs. defined benefit pensions
Defined contribution In a defined contribution scheme, the amount of money a defined contribution pension is worth on retirement depends on how much you have contributed and how your investments have performed.
The amount you contribute and how early you start have an overwhelming impact on how much pension you can expect in retirement. Too many people save too little and start too late.
What is a defined benefit pension?
A defined benefit pension (also called a 'final salary' pension) is a type of workplace or occupational pension that pays you a retirement income based on your salary and the number of years you’ve worked for the employer, rather than the amount of money you’ve contributed to the pension.
In a defined benefit scheme, the value of a defined benefit pension is based on:
- How long you’ve worked for the company
- Your salary while working: sometimes your final salary, or sometimes an average of your salary over your career
- The accrual rate: the proportion of your salary you’ll get as an annual retirement income. In a public sector pension scheme the accrual rate is typically 1/80th of salary for each year of service plus 3/80ths of salary for each year of service payable as a lump sum. Based on a 40 year service this provides for a lump sum of up to 1.5 times salary (the maximum permitted).
- The two benefits, pension plus lump sum equate to an accrual rate of 1/60th for each year of service giving a maximum total benefit of 2/3rds of salary.
Your employer is responsible for making sure there’s enough money in the scheme to pay you when you reach retirement. If your company gets into financial difficulty and can’t meet its pension commitments, in Ireland the following arrangements currently apply
Both defined benefit scheme and employer is insolvent
- 50% of the pension is protected for both pensioners and active and deferred members. Those on pensions of €12,000 or less are guaranteed 100% of their pension (Old Age Pension is additional).
- If there is anything left, the pensioners have their annuity topped up to 100%. Current/ deferred members have their benefits topped up from whatever (if anything) is left.
- If there is not enough money to cover the 50% minimum protection level (or 100% of pension is less than €12,000), the government will pay for it from general taxation.
Defined Benefit Scheme is insolvent, but employer is not
- Pensioners receiving pensions of less than €12,000 are prioritised and get 100% of their pension.
- Pensioners who receive between €12,000 and €60,000 receive 90% of benefits.
- Pensions who receive over €60,000 receive 80% of benefits.
- Once the retirees have been paid, the current/ deferred members receive 50% of benefits.
- If there is anything left at this stage, pensioners get their annuities topped up and then current/deferred members
- As the company is still trading, there is no government funding in this situation.
- The same type of structure applies in the situation where the pension scheme is being restructured.
- There are certainly more protections in place for those who have yet to receive their benefits. In the past, there were ranked so far down the list, they got little if anything after everyone else was looked after.
Defined benefit pensions are increasingly rare, but you may have one if you’ve worked for a large company or a public sector organisation.
Moving a defined benefit pension
Private sector defined benefit pensions (and some public sector pensions) are funded, which means you can get a cash value for your pension and transfer this amount to another provider.
However, it’s important to understand that you’ll lose the promised retirement income. Instead, your pension money will be invested into a defined contribution plan, and the amount it’s worth on retirement will be based on how much you’ve contributed and how the investments have performed.
If you’re in an ‘unfunded’ public sector pension scheme, you won’t be able to move your pension. That’s because this type of pension uses the employer’s current income to pay pension benefits, rather than setting assets aside.
Additional Voluntary Contributions (AVCs)
Many people with Occupational Pensions (both defined benefit and defined contribution schemes) also pay additional voluntary contributions or AVCs in order to boost their pension in retirement. These are an additional defined contribution scheme which runs alongside the employers main scheme.
Withdrawing money from your occupational pension
Defined benefit pension
Generally, your defined benefit pension pays you a retirement income, beginning at a certain age (60 or 65, for example). Your pension income typically increases each year to take into account the rising cost of living. When you die, a percentage of your pension can usually be paid to your spouse or civil partner or dependents.
Defined contribution pension
Retirement benefits from an Occupational pension can be taken in the form of a lump sum of up to 25% of the value of the fund plus an Approved Retirement Fund (a form of pension which remains invested to pay your income in retirement) or
A lump sum plus a guaranteed income in the form of an annuity for life
Pensions have become progressively restricted in recent years with the amount of the Lifetime limit reducing from over €5M to now just €2m.
Furthermore, only the first €200,000 of a lump sum is now tax free with the next €300,000 being subject to income tax at a rate of 20% and your marginal rate above that.
There are no zero cost and zero tax options so investors need to make a comparison between some different scenarios all of which could leave a financial benefit.
1) Continue to pay in and obtain the 40% tax relief.
Defer the pension to age 75. If you die before you reach age 75 your spouse or civil partner receives the whole value of the fund tax free. No income tax, no capital gains tax, no CAT and no penalty tax if you exceed the lifetime €2m allowance.
Conclusion: life insurance with tax relief on the premium
2) Gross roll up.
Let’s say you invest in equities and the return is say 7.2%pa net of charges to keep the maths easy.
Now let’s say a fund held directly also pays 7.2% net of charges but is subject to personal tax.
Your pre-tax €10k will be worth €20k in 10 years time.
Whereas if you invest the net income that’s going to be about €5000 which if you invest today you will have €10 in the fund (rule of 72)
You will then lose a further 41% in exit tax so €2,050 in tax. Net position €7,950 vs €20,000.
So let’s assume that you always have a marginal rate of tax of 50% and that you’ve used up all your lump sum entitlement. Taking that €20,000 as a lump sum fully taxable at your highest marginal rate is still going to leave you with a net €10,000 compared to €7,950.
In effect you received an interest free loan from Revenue and the difference is the gain on the income tax deferred.
If you invest in something that’s subject to CGT you will be taxed at 33%
If you pay income tax you will lose your marginal rate of tax (up to 55%)
So a pension gives you gross roll up relative to any other option you will have a larger gross fund in the future and the longer you leave it the more this will compound in your favour.
3) Taxable lump sum
Even if you have a pension fund of €800k and can use up the tax free lump sum the next €300,000 of lump sums is only taxable at 20%
4) Not all of your pension is taxable.
Imagine you have an ARF with €1m and you are forced to take an income of 5% which is subject to income tax at your marginal rate of 40% plus USC
In this example ; 95% of your ARF is not subject to tax. See earlier argument about gross roll up.
Assume your ARF grows by 5% net pa every year so the value rises back to €1m every year.
Effectively your ARF hasn’t paid any tax it’s constantly deferred. You are only paying income tax on the income distribution not the original tax deferred capital.
When you die your spouse or civil partner inherits the ARF then adult children inherit at a rate of 30% which doesn’t count towards the CAT thresholds so these are also available.
Had you held those assets personally and the CAT thresholds had been used up then the kids would pay an additional 3% tax €30,000 tax saved
5) Match withdrawals with medical expenses
Imagine you have an ARF with a million and in your 70s you incur €100k of medical expenses. That year you should take a larger withdrawal from the ARF partially to meet those expenses but partly because you can claim 20%tax back on medical expenses. That’s a €20 grand tax rebate
6) Transfer your pension to another EU Country
For those with higher salaries and therefore larger pension transfer values, it may be beneficial transferring to another EU country in order to access the pension benefits more tax efficiently. For example, some countries allow up to 30% of the transfer value to be paid as a tax-free lump sum.
If you would like to discuss your retirement plans, please get in touch