What is a defined benefit scheme with a money purchase underpin? Pensioner Members
There are many types of pension scheme offered by employers for their employees. This Factsheet looks at a variation of the defined benefit scheme – often called ‘salary-related’ pension schemes - which has for years been the most important part of many employees’ pension benefits.
It is written for people who are pensioner members of a defined benefit scheme with a money purchase underpin.
Introduction
This Factsheet takes a look at a variation of a defined benefit scheme. Even though there is an element of the pension benefit which is money purchase (i.e. an ‘underpin’), because a defined benefit scheme provides a ‘promise’ to the emerging pension, schemes with a ‘money purchase underpin’ are still regulated as defined benefit schemes. For more specific information on money purchase benefits see our Factsheet What is a money purchase scheme?
What is a defined benefit scheme with a money purchase underpin?
In its simplest format, a defined benefit scheme with a money purchase underpin will have provided you with two alternative pension options from the same pension scheme.
Whenever you drew your pension benefits you will have received the better of:
- a ‘defined benefit’ element of the pension scheme
- a ‘money purchase’ element of the pension scheme
You will not have received two pension benefits: just the better pension from one of the two alternatives.
So, what is a defined benefit scheme?
Most defined benefit schemes provide benefits based upon 4 key elements:
- the length of the pensionable service you were credited with whilst you were an active member of the scheme
- your pensionable salary
- the formula or rate of ‘accrual’ which will have used service and salary to work out your pension
- the circumstances under which benefits were taken from the scheme (retirement, early payment, early leaver, ill-health, death etc).
Your pension scheme will have used a formula, to calculate your pension benefits using these elements. The formula (and the definitions for each part of it) will be set out in the Scheme Rules.
The two most common forms of defined benefit scheme are:
- ‘final salary’ schemes where your pension would have been based upon your ‘final pensionable salary’ in the years immediately before you ceased to be an active member, and
- ‘career average revalued earnings schemes’ (CARE schemes) where your pension would have been based upon your ‘averaged pensionable earnings’ throughout the whole of the time you were an active member of the scheme.
Because both types of scheme use your pensionable salary as one part of the formula in order to calculate your pension, they are both commonly referred to as ‘salary related’ schemes, but there is a significant difference between the two.
Example:
Sue Evans was an active member of her pension scheme, and retired from work at her normal pension age. She was eligible to receive a pension from her employer’s ‘defined benefit scheme with a money purchase underpin’. She had been a member of the scheme for 20 years and her final pensionable salary (which was what her pension was based upon) was £30,000 p.a.
The defined benefit element earned her a pension equal to 1/80th of her final pensionable salary for each year she was in pensionable service (the ‘accrual rate’).
Pensionable Service, 20 years
Final Pensionable Salary, £30,000
‘Accrual rate’, 1/80th
Her pension from the ‘defined benefit element’ will have been:
20 years x £30,000
80
= £7,500 p.a.
If the pension benefit from her ‘pot’ in the money purchase underpin element of her pension scheme produced less than a pension of £7,500 p.a., Sue will have received the defined benefit pension.
However, if the pension benefit from her ‘pot’ in the money purchase underpin element of her pension produced more than £7,500 p.a., Sue will have received her pension benefits from that instead.
Some calculations can be very complex and involve other factors as well as those mentioned above.
What is a money purchase underpin?
As well as the ‘defined benefit’ formula, an agreed amount of the employer’s contribution and (normally) all of your contribution will have been invested in an investment fund (or series of funds). That fund or ‘pot’ will have grown and have accumulated interest or investment returns, until you reached the stage when your benefits were paid.
Depending on how much the ‘pot’ had grown to, the scheme (or their advisers) will have worked out how much pension the money in that ‘pot’ would have purchased.
The Trustees will have looked at both of the calculations (i.e. the pension available from the defined benefit element and the pension available from your money purchase ‘pot’), and you or your dependants will have received the higher of the two.
Are my benefits secure?
In a private sector defined benefit scheme with a money purchase underpin, your benefits are only as secure as the funds which have been set aside to pay for the benefits, and the employer’s willingness and ability to continue to support the scheme. As a pensioner member, your benefits will be more secure, but, as the saying goes, nothing in life is guaranteed (except taxes and death).
With the introduction of the Pension Protection Fund you may be entitled to ‘compensation’ if the sponsoring employer goes into receivership and your scheme meets the qualifying criteria set to allow compensation to be paid to scheme members.
In a public sector defined benefit scheme, such as those for nurses, teachers, local government and civil servants, benefits are generally regarded as ‘safe as houses’. Some of these schemes, such as the Local Government Pension Schemes, are ‘funded’ in the same way as private sector schemes but employer contributions come from local taxation such as Council, Local Business Taxation, and through Central Government settlements which come from the taxpayer.
These particular schemes would not qualify for the Pension Protection Fund, as it would be expected that the Treasury would one way or another, bail out any such scheme that suffered serious problems. This is clearly a highly political area.
What rights do I have as a member to ensure the scheme is run properly?
Any member can seek election to become a Trustee of their pension scheme, where there is a Board of Trustees. A Trustee is responsible for ensuring the scheme operates according to all the Scheme Rules.
If you are unhappy about any aspect of the scheme contact the Trustees, and if they do not satisfy you having formally pursued the Internal Dispute Resolution Procedure, you can contact The Pensions Ombudsman or The Pensions Regulator depending on your problem. Also, see our list of Useful Contacts.
Summary & Key Points
A defined benefit arrangement is a scheme which is financed by the employer (except for some public sector schemes); the benefits are calculated once the member reaches retirement age using a combination of pensionable remuneration, length of pensionable service and accrual rate.
A money purchase, or defined contribution scheme, is a ‘fund’ based pension arrangement where the members’ and/or scheme’s (where applicable) contributions are invested in a ‘fund’ or selection of funds. On retirement the member’s pension ‘fund’ or ‘pot’ is used to purchase benefits.
A hybrid scheme is a combination of defined benefit and money purchase.
An ‘underpin’ provides the scheme member with the best of the two benefits from either the money purchase or the defined benefit elements of the scheme, when the benefit becomes payable.
Remember:
- Keep informed. Your scheme may modify benefit or its Rules. Legislation may change. Your circumstances may alter.
- Rules differ from scheme to scheme and are wide and varied in content. Don’t assume that what applies to one of your pension schemes will necessarily apply to others that you may have.
- HMRC impose rules which registered pension schemes must conform to.
People seldom have identical pensions and you should avoid drawing comparisons with colleagues whose circumstances may at first appear the same but could emerge as having significant differences.
This Factsheet forms part of our Module Types of Pension Scheme and should be read alongside the other Factsheets and Quicknotes in the series.
This is not an authoritative document. Seek professional advice from an appropriately experienced and qualified adviser.
What is a defined benefit scheme with an MP underpin v1.4 – Pensioner
Last updated 15/01/2007
