In this week’s personal finance edition of Merryn Talks Money, hosts Merryn Somerset Webb and John Stepek discuss a listener question about the difference between UK defined benefit and defined contribution pensions.
The listener, Mustafa, said he originally had a defined benefit pension but has since moved over to a defined contribution scheme. He wants more information about each of the pension types and is starting to question the change. Webb and Stepek help him understand the pros and cons of each scheme and make it very clear what they might prefer for their own pensions.
Bloomberg Audio Studios, Podcasts, radio news. Welcome to Meren Talks Your Money, the personal finance edition of Merin Talks Money. In these bonus podcasts, we talk about the best strategies for making the most of your money. I'm merensum Set Web and with Me senior reporter and Money to Soiled author John Stappeck Hi, John hil So. Budget is over. Things are a little more clear now. Of course, are not any more clear at all, but some things are a little more clear. That means we can now answer some of the personal finance questions with a little bit more clarity. We're not always going to be saying depending on the budget, depending on the budget, depending on the budget. We're now going to say depending on the next budget, depending on the next budget, depending on the next budget. Because we know this isn't this isn't over looking at you know, there's incredibly high level of span, incredibly high level of TAXI GDP, very low growth, etc. Know that she's going to be needing more, she's going to be back. We don't know what she's going to be wanting next time. But it's not over, so we're always going to caveat everything with there are more budgets to come and we have no idea what's going to happen in them, so everything that we say must be taken with that in mind. Is that fair?
Oh, that's fairly fair, especially when it comes to today's topic.
Yeah, and it would be fair regardless of who was in government, if I'm honest.
Yeah.
Right, So this week we want to talk about something incredibly important and something that really really agitates me and John, and you'll probably have heard us saying over and over and over on the podcast and writing over and over that we do anything, almost anything bar selling our children, but pretty much anything else to have a defined benefit pension instead of the defined contribution pensions that we do have. So Withstafa, who's been listening to us going on about this for a while, have finally asked the right question, He says, I have heard you regularly wish you had a defined benefit pension. I do have one, but since the first of April, I have transferred for defined contribution pension. Am I being a fool?
Well?
I have to say my first thought when I saw that was first of April. Please God let it be a joke. But I think I think it probably isn't. Let's start off with defining what this actually has done. What's a difine benefit pension. What's this thing you want so very bad but not enough to go work in the public sector quite badly, but not that badly.
Yeah, well there is that. So defined benefit pension means that when you retire, you get an amount of manual income that is proportionate to your salary over your lifetime. So at the moment, most faint benefit pensions, they used to be final salary now their career average. But all that means is that over the length of your career, it's the average your salary over that time, and you get paid a certain amount of it once you retire. And the important thing is that that's guaranteed and it goes up with inflation. So you don't have to worry about doing anything other than doing your job, and you never have to worry about investing money for your retirement over and above perhaps anything that you want to do in the side. So it's just a very straightforward way from an employee's point of view of saving for the future.
All the investment risk here, or all the risk of having enough money to pay out the pension lies with the employer. And when I say it lies with the employer, I mean it occasionally lies with what you might think of as an employer, because there aren't very many of these schemes left around in the private sector, right, So in the old days, pretty much everyone who had a pension had to define benefit pension gradually because they are very expensive. Will come on to that they've gradually disappeared. There are now well hundred a million people in the private sector with defined benefit pensions that are still accruing all other defined benefit pensions. Many many millions of them are in the public sector. So eighty two percent of those who work in the public sector have a defined benefit pension on the go. So when I say the risk of these pensions rests with the employer, what I really mean is the risk rests with the public sector, by which I really mean the risk of their pensions rests with you, the taxpayer, lucky. So that's how it works. This pension income. The great thing about it, as Johnson, it arrives every single month. You get paid regardless of what happens. And this, of course the country goes completely bust and other taxpayers can't continue to provide fewer retirement This could happen, but it's not looking likely in the immediate Do you get that money now in the private sector, if you have a private sector dB, you may get inflation linkage, well, you will get inflation linkage, but it's not guaranteed to be to the actual RPI or the actual CPI. You may have a cap which is sometimes three percent a year or five percent a year, which means that quite a few people in private sector defined benefit schemes stout during that period of very high inflation. So in periods when inflation was above ten percent, they may have found they've only gotten up left with three to five percent. But nonetheless that's probably better than those words in the private sector managed on our defined contribution pensions. So that's a defined benefit pension, and you can see how incredibly attractive it is. There's one more thing to add to it on its enormous attractions, which is the amount that employers tend to contribute. In the NHS, the employer the public sector, the taxpayer contributes around twenty four percent nearly twenty four percent of a salary into the pension scheme for the employee. The employee themselves will will put in anything from five point two percent to twelve point five percent, depending on where they sit on the income scale. In the civil service it's pretty good too, you get twenty eight point ninety seven percent. There are various different schemes, but that seems to come out around there all the time. And the low government it's fourteen to eighteen percent. So your employer, the public sector is putting just to be clear, it's putting a lot of money into these schemes. Now, let's shift from that very pleasant sounding thing. Although I will say that, and it is fair to say this job before we go any further, just because you're in a defined benefits game doesn't mean you're going to spend your retirement rolling around in money. If you were making twenty five thousand pounds in the public sector before your retirement, you're going to be getting considerably less than that as your pension. And I would also say that there is a saying where because the contribution levels from the employee are reasonably high, they can be you know, five six seven percent. It is the case that a lot of low earners in the public sector opt out of their pension, and that's a major problem, not medium owners or higher. And as they all stay up to tend very sense of a word at the bottom, they're going to be people who say, do you know what, I'm only earning fifteen thousand pounds, I can't afford to put anything into a pension, regardless of the fact that my employment might be adding another twenty percent plus just too much. I say, that's a problem. Lovely southing nice isn't define contribution, define contribution pension.
Or define contributions the opposite. So really you just have to save into sometimes call a pot, but we prefer to call a rapper tensions rapper that carries various tax advantages but really ignoring them. It's on you to save up as much as you think you're going to need to fund your retirement when you retire, and when you retire you can use that pot in various ways, but the point is it's not protected in any way and there is no guarantee. All of the risk is on you. And I think to get a sense of how much more beneficial the defined benefit pensions are for auto enrollment, which is define contribution schemes, your employer contribution is as little as three percent and your your kind of contribution will be five percent from your gross salary, and obviously some employers are more generous than that. But the point is that even a generous sort of like generous package by defined contribution terms would be much lower than the civil serve is nearly a third to your wage getting paid by your employer on top and it's not going into your pension scheme. But that's the point. That's the cost to the employer for providing you with that pension. So yeah, so the risk is all on you, and that's that's for the entire period, including Jurdan retirement.
I mean, you're not necessarily making the investment choices. Obviously a lot of people don't even know they have a defined contribution pension at all. It's just a pension. But what's happening is that their contribution and employers contribution are being paid into a fund of some sort. Normally horribly performing in high fever will come onto that another time, and that the idea is that grows throughout your working life and at the end there's a lumpsum that's enough to pay you out a reasonable income. And we've looked at this before. It is true that if you work on an average income, you get a reasonable uplifting your salary every year, and you come out the other end having saved the maximum your employer allows them the pension added to the state pension, you should be just about okay. But you're just about okay without the certainty and inflation uplift that you get with a dB. So, although it doesn't really matter how you cut it, a dB is a better deal for an employee than a DC or.
On that inflation point. This really is important because even if you get an annuity, which most define contribution people don't at the moment, you still aren't going to be able to buy one that buys you the kind of protection. I mean, I was hauping to look at the civil service pension before we came on as well, and we're obsessed. And during the they can have very inflationary period. So they got ten point added to the pension in April last year because that was the reference period. So no one in the private sector, I mean, if you did get ten point one percent would be interested to hear it. But I don't think anyone would have unless you get some very obscure dB set up from a long time ago. So it really is a major and major benefit, and that would be extremely expensive to putures in the open market, even if it was possible we do.
So. The one thing that might have made a DC more attractive than a dB, and maybe something to do with my stuff is shift. We don't, by the way, know anything about my stuff as actual situation. Why he shifted from pension to pension. We don't know whether that's actually about changing jobs. We don't know whether a positive decision or not. We have no idea what happened there was just all we have is the question that he asked us. So no judging here, no judging here. But until this latest budget, it was possible to leave your defined contribution pension effectively your step to your airs tax free. So they did not pay tax on receiving it. They and if you were under seventy when you died, they paid no tax on it at all.
Over seventy five, sorry.
Under seventy five and five over seventy five, he paid your personal rate of income tax on withdrawing money from the pension. There, I John, yeah, yeah, So that made it a very attractive thing to do, and financial advisors had begun over the last decade or so to advise people to leave their money inside their pension and spend all the money that they had outside that pension first, because that was the most tax efficient way to leave money to their heirs. So that was one reason why a lot of people, I mean a lot of people transferred from dB to DC, and particularly when interest rates were extremely low and so the capital value of defined benefit pensions was very high, you could shift that into a DC wrapper and think to yourself, this is great, My airs are going to be rolling around in cash, which of course lots of them, but not anymore.
Yeah, we talked about this the other week. But the thing is, when this first happened, it seemed regious, and it did seem like something that was bound to be cracked down on eventually. It's unfortunately it's taking a government this long to do it, so that it has become part of a lot of people's retirement planning and it really does change it. I mean, you know, there was a point where, like you say, advisors were saying, right, you'll put money on your pension, but don't touch your pension until last whereas now you're probably going to be better to actually take your pension before say your eyes are because although your eyes will attract inheritance tax, the actual money will then be free of income tax once you know you're withdrawing it. If you've passed it on to a spouse, it's not a spouser and inherited. Whereas the thing with the pension is that not only is i HD taken out when they take the income from it, that'll get tax too. So you're like, kind of makes the sequencing completely different from what a lot of people will planned. So that's you know, there's gonna be a lot of interest and knock on effects from this, and most of them are not going to be, you know, ones that people feel very happy about if they had been relying on this as a plan in two.
Yeah, so the thing to do now is to do gifts out of income, to take money out of the pension and hand it on on the gifts out of income exemption actively, isn't it.
Yeah? Yeah, And yeah, let's say, oh, those kind of elements. I'm sure that people who will charge you a lot of money to explain to you about doing Yeah.
Yes. The other group of people who might not be particularly impressed by this, of course, is the platforms, because nothing an investment platform more. Indeed, a fund manager really kind of likes more than sticky money. So the idea that people were very gaen to keep as much money as possible inside their pension rappers for as long as possible was very attractive for financial product providers. So they might be markedly irritated by this, but possibly not as irritated as people who moved out of dB into DC in order to leave their money tax free. So I think that's it. Is there anything that we've missed out of that?
I mean, I suppose. The other point to remember is that if you want to transfer from a defined benefit pension to a defined contribution pension, you will struggle to find an advisor who will give you advice on that. And the reason for that is because the FCA comes down like a ton of bricks or anyone who hasn't, you know, completely made sure that it's definitely the right thing for the client. So the risk of miss selling or being accused of miss selling is extremely high. And the reason for that is because for the vast majority of people, define benefit pension is a lot better than a defined contribution pension. I know you occasionally see people trying to make contrarian arguments kind of online about this, but you know, it really is one of those things where you have to have a very very weird set of circumstances for the DC to be better than the dB. Certainly as far as I can.
See, well, there was a point. That point no longer exists, but I only mildly disagree with you, junks. I wouldn't want it to more than that. But there was a point back when interest rates were insanely low, and of course to lower the interest rate, the value of the assumed the capital sum that pays out your dB. So there was a point when interest rates were extremely low that pensions that would have provided a very small stream of income were suddenly worth a very large sum of capital. So there was a moment in the interest rates I got when you could argue, and I think I might even have argued there was a point when it was reasonable to do it, but it was a pretty short window. I remember modern Wolf in the Ft he did it, and that called a lot of conversation. But of course, you know he'd done his maths pretty well, done his math pretty well.
Yeah, I was a great taming call.
Yeah, yeah, anyway, but now it's rather more complicated with rates where they are and possibly staying higher for longer. But that's a conversation for a different part of this podcast. I think that's kind of it so much tofi there you are. I don't think we can answer the question was it foolish to move? Because we don't know your circumstances. But I think what we would say in general, in general, is that John and I would still even after this conversation. Really, I really love a dB patchion. Thanks for listening to this week's Maren Talk to Your Money. If you like us, show, rate to review, and subscribe wherever you listen to podcasts also be showed follow me in John on x or Twitter at marinsw and John Underscore Steffecht. This episode was produced by SOMEERSIDI, production support and sound design by Moses and Questions and comments on this show and all our shows always welcome, and that's particularly the case, by the way, on these personal finance ones, because John and I are not IFAs and we are not accountants. So if you know something we don't know, do please write in and let us know. Our show email is merin Money at bloomberg dot Net,