Early Payment - Preserved Members - Defined Benefit Schemes

Introduction

When would you like to retire?

A common immediate response is ‘tomorrow’. In reality, many people don’t want to retire early, and few of us could actually achieve a comfortable income by taking our pension benefit before it is due – unless of course we have successfully planned to do so. Early payment penalties, personal finances, health, the impact upon social security benefits, interest and annuity rates are some of the areas which can affect this planning and make early payment difficult to achieve. This Factsheet only looks at the issues related to scheme benefits to help you in that planning. You will then be able to give a considered response to the question of when you would like to retire.

To begin with, your Scheme Booklet will probably give details of early payment options, if your pension scheme allows it. However, many Scheme Booklets focus upon active members and are less detailed when it comes to providing information for preserved members.

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Can I retire early?

Your Scheme Rules will define your Normal Retirement Date. For most people this will be between ages 60 and 75. The HM Revenue and Customs (HMRC) rules allow schemes to provide early payment for their members - although it is up to your pension scheme whether it chooses to incorporate this option within the Scheme Rules. So, whether you can draw benefits earlier than your Normal Retirement Date or not, will depend upon your Scheme Rules.

To find out if your scheme allows early payment you should get a current copy of these rules and if you are still in doubt, you should write to the administrators of your scheme to ask for details, stating that you are a preserved member.

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Do I need consent?

Your Scheme Rules will determine whether you have the:

right to draw your pension benefit before your Normal Retirement Date (i.e. an entitlement) or
whether you have the option of early payment (i.e. discretionary).

You may possibly have a contractual right to early payment, previously specified through a redundancy agreement, or because your scheme had merged, or you were part of a transfer of employment (TUPE). These agreements should be endorsed by the scheme Trustees, otherwise you might find the right unenforceable if the sponsoring employer ceases to trade before you want your benefit.

In some pension schemes, early payment can be:

subject to the consent of the Trustees (‘discretionary’),
subject to the consent of the sponsoring employer (‘discretionary’), or
subject to the consent of both the Trustees and the sponsoring employer .

The Trustees, or the sponsoring employer of your scheme, may allow early payment for one member but not for another, or for one section of the scheme but not another. The Trustees themselves will tend to be very careful in not discriminating against any individual member or group, but the employer is more at liberty to select particular solutions to particular circumstances.

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What if I am refused an early retirement?

If early payment is not permitted, you can still access your benefits early by transferring them into a pension arrangement in your own name. You would need to check the rules of the policy you were transferring into, to make sure that payment would be permitted at the age you wanted to draw your benefits. Any penalties and disadvantages of taking your benefits early would need to be carefully considered. This is a complex issue and it is essential that you get independent advice from a pensions specialist to see if this would be beneficial to you.

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At what age can early payment begin?

This will depend upon your Scheme Rules which will usually specify the earliest age at which you would be allowed to draw your pension benefit. There is no legal requirement that a defined benefit scheme has to provide for early payment.

Except for early retirement on the grounds of ill-health, early payment before age 55 is not possible (other than for a few pension schemes which have prior agreement with HMRC). The minimum age HMRC will allow pension schemes to provide benefits (other than on ill-health) increased to age 55 (from age 50) on 6th April 2010.

Many schemes that provide early payment, do so from a specific age (e.g. 55, 60).

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Will I be penalised if I am granted early payment?

Common sense tells you that if you draw your pension benefit early you will receive the benefit for a longer period. This means that you are likely to receive a lower pension than had you waited until your Normal Retirement Date.

However, some scheme members may have more favourable early payment terms than others, for reasons that we mentioned earlier (TUPE, redundancy agreements etc.). This might mean that any early payment penalty that the scheme would normally apply, is reduced. Alternatively, there may be no penalty - or in exceptional circumstances, early payment may even include an enhancement to your pension benefit (often used to help those being retired before their State Pension falls due (see ‘bridging pensions’ below).

Some criticism has been made in the media about the abuse of ‘favourable terms’ where this has been used by a pension scheme to benefit only certain members of a scheme, such as senior employees or directors. The Trustees should in these situations, ensure that the employer is paying for the extra value of these benefits, rather than the scheme (and therefore the other members).

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Penalties, Discount Rates and Reduction Factors

As is often the case with pensions, the terminology used by schemes, administrators and advisers to describe any reduction to your pension for early payment, can be confusing. Clearly, it is essential that you know what you are going to get in terms of your pension benefit if you choose early payment.

If you are being given the option to early retire, you will able to request the precise details of your pension benefits. If you are planning for your early retirement (or early payment) at some point in the future, then understanding how penalties are applied can be very important. If you have any concerns you should get independent financial advice from a pensions specialist.

One scheme’s penalty, is another scheme’s reduction factor or discount rate. They can all mean the same thing – or all mean different things (and to different people).

Examples of some methods of early payment calculations:

Let’s imagine that your Normal Retirement Age is 65 at which point your estimated pension is £20,000 p.a. (allowing for assumed future inflation to age 65). You are planning to apply for early payment at age 60 and at that age your estimated pension before any reduction is applied will be £17,500 p.a. (allowing for assumed future inflation to age 60).

Assume there is a penalty (e.g. 4%) for each year your benefits are taken early (simple interest). Hence, there would be a 20% reduction (4% x 5 years).

if your scheme applies this to your estimated pension at age 65 your pension will be (£20,000 - 20%) = £16,000 p.a.
if your scheme applies this to your estimated pension at age 60 your pension will be (£17,500 - 20%) = £14,000 p.a.

There are different ways that pension schemes can calculate early payment and you can see from the above example how this could have quite an impact on your retirement.

If early payment is available and the amount you can have makes it a realistic prospect for you, it makes good sense to ask exactly how your scheme will calculate your pension benefits. Request a worked example that would be relevant to your pension benefit.

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Can my pension scheme withdraw the option of early payment?

Whilst your pension scheme may have previously allowed early payment for members, don’t assume that it will always be available in the future. It may well continue to be – but your pension scheme, or sponsoring employer, may have the ability to withdraw it. An option is not a right.

You should check the terms of your contract of employment. If the early payment option was included as part of your terms of employment, your employer will have to negotiate directly with you. It is important to appreciate that your contract of employment was with the employer, not the pension scheme. If the employer ceases to trade the Trustees may be unable to support options that might have been available had the employer survived.

If you are therefore planning for early payment, it is important that you keep appraised of whether it remains open to you. Once you have taken up the option of early payment and started to receive your pension benefit, the scheme cannot withdraw it unless the scheme is wound up with insufficient assets to pay full benefits.

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Waiting a short while could improve your pension

Not everyone would benefit from taking their early payment pension on a birthday (e.g. at age 55 or 60). You may be one of those scheme members who would be better waiting a while to maximise the benefits payable to you on early payment. It may mean waiting a few weeks or months, but the difference could be worthwhile. It can depend upon a number of factors but your scheme administrators should be able to help you identify whether, and how, you could maximise your pension. As this could involve giving you advice, your scheme administrators or employer may not be registered with the Financial Services Authority to provide you with advice, which means that you will need to get independent advice from a pensions specialist.

There are many different methods of working out what a member’s pension would be for early payment, and this would be detailed in your Scheme Rules. Some methods can be quite complex.

Example of two basic methods

John Smith left his pension scheme on 10^th February 1997. He wanted to early retire at age 58 on 3rd December 2005, which was 8 years and 9 months later. His pension at leaving was £12,600 p.a. Let’s assume that his pension received inflation increases of 3.25% p.a. between leaving and age 58. What would his pension be (before any penalties were applied)?

If his scheme used only the Whole Years in working out the projected pension from which the early retirement pension would be calculated, John’s pension would be

£12,600 x 3.25% p.a. x 8 = £16,274 p.a.

If his scheme used Years & Months completed, John’s pension would be

£12,600 x 3.25% p.a. x 8.75 = £16,668 p.a.

If John’s scheme used the Whole Years method, he could have considered delaying his early retirement for just a couple of months until after 10th February 2006 when the number of completed years would have risen to 9. His pension would then have been:

£12,600 x 3.25% p.a. x 9 = £16,802 p.a.

This represents an increase of £528 each year before any early payment penalties are applied.

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Pension Increases once your pension commences

Increases to your pension in payment are called ‘escalation’ (whereas increases to your pension before payment are usually referred to as ‘revaluation’). You may receive different rates of increase to different parts of your pension. Your scheme will be able to tell you what increases you get and whether these alter at different ages. Once your pension is in payment, pension increases can be:

Statutory - determined by legislation, these increases are required by law and cannot be changed
Guaranteed - these increases will be applied as they will have been written into the Scheme Rules
Discretionary - as the name suggests these are optional increases notified from time to time
Catch-up - sometimes used to address the impact of inflation over a period of years where the scheme hasn’t provided adequate inflation protection on some benefits

Discretionary and ‘catch-up’ increases were quite common in the eighties and nineties, but have become less common in recent years, with low inflation and much higher statutory increases. They may be granted on a regular or irregular basis. Some schemes may have a ‘published practice’ (e.g. ‘discretionary increases matching inflation up to 70%’).

If your pension benefit is paid early, the amount of any increases may change once you attain Normal Retirement Age (or State Pension Age if this is later than when you plan to take early payment).

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Step-up pensions, Bridging pensions, Pension Deductions & Offsets

Step-up pensions, Bridging Pensions or Pension Deductions generally involve the way your pension benefit interacts with the Basic State Pension Scheme or its obligation to provide a minimum pension as a consequence of the scheme being contracted-out between 1978 and 1997. They will only apply for a fixed period or from a fixed date after the pension has started to be paid.

Step-up pensions and Bridging Pensions may also be used as a method of ‘levelling-up’ pension benefit due to Equalisation (which addressed most sex discrimination issues in pension schemes). Not all defined benefit schemes operate Step-up pensions, Bridging Pensions, Pension Deductions or Offsets, but it is important to identify whether yours does, and if it does, whether it will apply to your benefits.

Step-up pensions, Bridging Pensions or Pension Deductions usually apply when pension benefit is paid either:

before Normal Retirement Date as an Early Payment or
before State Pension Age (i.e. if your Normal Retirement Date is 60, but your State Pension Age is 65)

and then no longer apply once you have reached State Pension Age.

Each of these terms could be described as follows:

Step-up Pension: as its name tends to suggest, is an addition to your pension benefit at a given age. Your pension scheme will calculate the amount to be added to your pension and should also explain to you the reason for the Step-up.

Bridging Pension: would usually be in the form of a ‘temporary’ pension payable between two dates. The reason for the Bridging Pension should be provided by your pension scheme who will also calculate the amount.

Pension Deduction: would see your pension benefits reduce by an amount at a particular age. It could be levied for a number of reasons. The reason for the Pension Deduction should be provided by your pension scheme who will also calculate the amount.

Offset: would usually involve the process of a pension scheme granting pension increases (escalation) between early payment age and State Pension Age and setting these against any increases in Guaranteed Minimum Pension you may have if you were Contracted-out of the State Earnings Related Pension Scheme between 1978 and 1997. The amount of Offset would be calculated by your pension scheme.

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Pension Protection Fund issues

The Pension Protection Fund (PPF) was set up in April 2005 to pay compensation to members of defined benefits schemes whose sponsoring employer failed. A pension scheme must undergo an assessment by the PPF before members become eligible for compensation.

Where a scheme is accepted by the PPF, members who have already reached their scheme’s Normal Retirement Age will receive 100% compensation up to a ceiling, currently £30,856.35 at age 65 (effective from April 2008).

All other members – including those who have received their pension from their pension scheme under early payment terms – will receive 90% compensation (i.e. currently a maximum of 90% of £30,856.35 = £27,770.72 from April 2008).

Pension increases during retirement from the PPF for all pensioner members may also be lower than the increases you would have received from your pension scheme before it entered into the PPF.

For more details go to the PPF website.

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Summary & Key Points

When making enquiries about your pension benefit it is very important that you make it clear whether you are a preserved member rather than an active member or a pensioner member. Active, preserved and pensioner are different classes of membership of a pension scheme and any definitions and paragraphs contained within your Scheme Rules or scheme literature relating to any benefit may differ considerably between these categories.

On average, people change jobs every 5 to 6 years. It is possible therefore, that you will have more than one pension benefit. For each pension benefit you need to consider the following items:

Would you, as a preserved member, be eligible to draw your pension benefit before your Normal Retirement Date?
Would you require consent from the sponsoring employer, the Trustees or both?
Do you have a contractual right to draw your benefits early?
What penalties apply to your pension benefit if taken before Normal Retirement Date? (Obtaining a list of these should illustrate if it is better to draw benefits at a particular age).
How is your pension calculated on early payment?
- is it calculated up to the age you want to draw benefits early?
- is it calculated up to your Normal Retirement Date?
- what, if any, assumptions have been used (e.g. for the future rate of inflation), and are these assumptions realistic?
How will your pension increase (escalation) once in payment? Will the rate or method of increase change at a particular age? (e.g. if you reach State Pension Age after you commence drawing your pension benefit).
Will there be any Step-up Pension, Bridging Pension, Pension Deduction or Offset?

Don’t assume that you will receive the same terms or benefits as your colleagues. You may be in a different category of the scheme, or they may have had different terms to their employment contract.

Keep informed. Your scheme may modify benefits and Rules. Legislation may change. Your circumstances may alter.

This is not an authoritative document. Seek professional advice from an appropriately experienced and qualified adviser.

Early payment v1.4 Preserved

Last updated 06/12/2006

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