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19th October 2019
:: Scheme Member | Types of Pension Scheme | What is a money purchase scheme with a defined benefit underpin? | Active members of a DB scheme

What is a money purchase scheme with a defined benefit underpin? – Active Members
There are many types of pension scheme offered by employers for their employees. Money purchase schemes have become the most common type of scheme for most new employees in the private sector. This Factsheet looks at a variation of an employer sponsored money purchase scheme.
 
It is written for people who are active members of a money purchase scheme with a defined benefit underpin. 
 
Introduction
 
This Factsheet takes a detailed look at a variation of money purchase schemes – which provide some measure of ‘promise’ to the emerging pension. Because of this ‘promise’, these schemes are regulated as defined benefit schemes. For more information about what this means see our Factsheet What is a defined benefit scheme?
 
It is written for people who are active members of an employer sponsored money purchase scheme with a defined benefit underpin.
 
To understand what a money purchase scheme is, you ought to know the very basics about employers’ pension schemes. See our Factsheets What is a pension scheme? and Types of employer sponsored pension schemes. There is also a more detailed explanation in our Factsheet, What is a money purchase scheme? which you should read in conjunction with this one.
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What is a money purchase scheme with a defined benefit underpin?
 
In its simplest format, a money purchase scheme with a defined benefit underpin provides you with two alternative pension options from the same pension scheme.
 
Whenever you draw your pension benefits, you will get the better of: 
  • a ‘money purchase ’ element of the pension scheme
  • a ‘defined benefit’ element of the pension scheme
You will not receive two pension benefits: just the better pension from one of the two alternatives.
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So, what is a money purchase scheme?
 
A ‘money purchase scheme’ provides benefits based upon the amount of money that is in YOUR own ‘pot’ when benefits are due to be paid.
 
The amount that will be in your ‘pot’ when benefits arise will depend upon the payments made into your ‘pot’, the investment return achieved on each individual payment to the pot, and any costs which are charged against your growing ‘pot’. The benefits you or your dependents will get from a money purchase scheme will come entirely from your ‘pot’.
 
Employer-sponsored money purchase schemes include Contracted-Out Money Purchase Schemes (COMPS), Contracted-In Money Purchase Schemes (CIMPS), Executive Pension Plans (EPP) and Small Self Administered Schemes (SSAS).
 
Other types of money purchase schemes include Personal Pension Plans, Stakeholder Pensions (Stakeholder or SHP) and Group(ed) Personal Pension Plans (GPPP). These arrangements may be presented as employer schemes but in fact are personal arrangements rather than employer sponsored schemes (even though your employer may pay into them on your behalf). None of these provides an alternative benefit.
 
Summary
 
In an employer sponsored money purchase scheme your ‘pot’ will usually consist of - 
  • employer contributions   plus 
  • YOUR contributions        plus
  • investment returns        less 
  • charges
What is in your ‘pot’ at retirement will be used to provide you with your pension benefits.
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What is a defined benefit underpin?
 
Most ‘defined benefit underpins’ provide YOU with benefits based upon 4 key elements: 
  • the length of the pensionable service you are credited with as being an active member of the scheme
  • your pensionable salary
  • the formula or rate of ‘accrual’ which uses service and salary to work out your pension
  • the circumstances under which benefits are taken from the scheme (retirement, early payment, early leaver, ill-health, death etc).
Your pension scheme will use 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.
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Example:
 
Jennifer Grant is an active member of her pension scheme, and is retiring from work at her normal pension age. She will receive a pension from her employer’s ‘money purchase scheme with a defined benefit underpin’. She has been a member of the scheme for 20 years and her final pensionable salary is £30,000 p.a.
 
The ‘defined benefit underpin’ earned her a pension equal to 1/120th 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’,                    1/120th
 
Her pension from the ‘defined benefit underpin’ will be:            
 
                                      20 years    x    £30,000
                                         120
 
                                      = £5,000 p.a.
 
If the pension benefit from her ‘pot’ in the money purchase element of her pension scheme produced less than £5,000 p.a., Jennifer will receive the defined benefit underpin instead.
 
However, if the pension benefit from her ‘pot’ in the money purchase element of her pension produces more than £5,000 p.a., Jennifer will receive her pension benefits from that instead.
 
The Trustees look at both of the calculations (i.e. the pension available from the ‘defined benefit underpin’ and the pension available from your money purchase ‘pot’), and you and/or your dependants will receive the higher of the two.
 
Some calculations can be very complex and involve other factors as well as those mentioned above.
 
For more information specifically on defined benefits see our Factsheet What is a defined benefit scheme?
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What benefits are provided by a money purchase scheme with a defined benefit underpin?
 
In current market conditions, it is quite likely that the defined benefit pension may be greater than the pension that can be bought by the money purchase ‘pot’. If this is the case, the way the benefits are paid will depend upon what the scheme rules say. 
 
However, if the money purchase benefit is larger, the benefits that your pension scheme would provide depends largely on what you want, and your personal circumstances, when you want to draw the benefit.
 
A money purchase scheme with a defined benefit underpin, can either provide an income for life (commonly referred to as a pension) or an income and a lump sum.
 
The ‘shape’ of that income depends upon whether you want a larger benefit payable immediately, or a smaller amount initially but which enjoys a measure of inflation protection (in the form of regular increases to your pension in payment – called ‘escalation’). The more inflation protection you have, the smaller the starting pension. This can create major complications if the choice brings the defined benefit ‘promise’ into play. If this happens, your scheme administrators will go through the options with you, at the time your benefits become payable.
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Example:
 
How much pension could a £100,000 pension ‘pot’ provide for a male aged 65 -
 
Pension            Increases to pension               Dependant’s
                      after retirement                    pensionon death
 
£6,752 p.a.                       Nil                                   Nil
 
£6,152 p.a.                       Nil                                   50%
 
£4,880 p.a.                       3% p.a.                            Nil
 
£4,316 p.a.                       3% p.a.                            50%
 
Based upon a £100,000 pension ‘pot’ for a male aged 65 at 22/09/2006, no guarantee period. Figures will vary from time to time and should not be relied upon.
 
If you choose to provide a pension for your partner or dependent to be paid to them on your death, the amount of initial pension payable to you will be lower. If you choose full inflation protection and a generous dependant’s pension, your starting pension will be lower still.
 
Most schemes also provide a lump sum death benefit should you die before your pension starts. This could be based solely on your ‘pot’ or perhaps a further amount based upon an insurance arrangement paid for by your employer, or by a deduction of a charge from your ‘pot’.
 
There may be specific death benefits payable from the ‘defined benefit underpin’ element payable in addition to any death benefits from the money purchase element of your pension.
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Did I have to join my pension scheme?
 
You are not normally obliged to join, but your employer may automatically enrol you in the pension scheme. Alternatively, you may be required to work for your employer for a specified period, before you are eligible to join the pension scheme (e.g. 12 months). For more information see our Quicknote, Did I have to join my pension scheme?
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What earnings are used in calculating my pension?
 
The calculations of pensionable salary (sometimes also called pensionable earnings) can be very complex and can involve factors such as maximum amounts to be taken into account, or exclusions of certain types of earnings (e.g. bonuses, overtime). This is important as the amount of contributions to the money purchase element of your pension will be based upon your pensionable salary. Your pensionable salary may also be used as part of the formula in respect of the defined benefit underpin element.
 
Your Scheme Rules will define precisely what is used to calculate your defined benefits as well as the amount that will go towards your money purchase ‘pot’.
 
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What counts towards ‘pensionable service’?
 
The Rules of your pension scheme will define what period of your actual service will be classed as your pensionable service. It is not necessarily the full period of your employment as you may have commenced work before you were eligible to join the pension scheme.
 
Once again, this is very important as the defined benefit element of your pension will be based upon your pensionable service. For more information see our Quicknote, What counts towards pensionable service?
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When can I get my pension benefits?
 
Benefits will normally be payable to you when you reach your scheme’s normal pension age or Normal Retirement Date. This is important as it is the date at which you would normally be expected to start to draw your pension benefits without the consent of the employer or the Trustees.
 
Depending upon the rules of your scheme (not all schemes allow these alternatives), you may also be entitled to receive benefits at other dates such as: 
  • Early retirement
  • Retirement due to ill health
  • Terminal illness
  • Late retirement (where you choose to work beyond normal pension age).
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Can I calculate these benefits now?
 
If you are an active member your regular benefit statement should indicate what you might get at normal pension age based upon the contributions you have paid so far, and expected future contributions, including an allowance for investment growth.
 
Your statement should also refer to the ‘defined benefit underpin’ and may tell you what your ‘underpin benefits’ are worth to date.
 
The amount of your ‘defined benefit underpin’ element should be more specific (than your money purchase benefit). It is likely that this will be a definite figure. To estimate what your ‘defined benefit underpin’ benefits will be worth at retirement will depend upon a number of factors.
 
These figures clearly do not guarantee what benefits you will actually receive at normal pension age as circumstances in the future will differ from those assumed in the statement , but the figures should help you plan for your retirement.
 
If you do not have a benefit statement or want to know how much your benefit would be at alternative dates, you should contact your scheme administrator.
 
The benefits will include a pension and will also include the option of a lump sum payment at that date (usually in return for a reduction in the amount of pension you receive). Benefits may include a spouse’s pension and dependents’ pension, payable in the event of your death after retirement.
 
Some schemes provide a lump sum death benefit, part of which can be paid from a separately insured life insurance arrangement.
  
Remember, at retirement a comparison will be made of both of the ‘money purchase’ benefit and ‘defined benefit underpin’ elements of your pension benefits and you will receive your pension benefits based upon the better of the two alternatives.
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Are the assumptions used in projecting my pension benefits at retirement realistic?
 
Your benefit statements, which aim to show what your pension benefits will be worth when you draw them, are based upon a set of assumptions which are determined by the Government and therefore only provide an indication of what might emerge for you. The amount in your money purchase ‘pot’ at that time will depend upon the actual investment returns on your monies paid into your ‘pot’ by your and your employer.
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How does my ‘pot’ grow?
 
The contributions which you make, and which your employer makes, are invested in a range of investments or investments funds. Those funds may be selected by the employer, or YOU, or where the scheme is administered by Trustees, they may design the fund selection with the help of investment specialists. You may have the option to switch between different types of investments or investment funds.
 
The existence of the underpin pension will mean that a proportion of the contribution MUST be invested in certain funds selected by the Trustees of the scheme. This helps the scheme make proper provision for the ‘promised’ pension. You will only have control over the remaining proportion of the investments in your ‘pot’.
 
In many schemes, contributions into your ‘pot’ may be held in a ‘default’ fund if no specific investment fund has been chosen by YOU.
 
Some pension schemes have an automatic switching arrangement which operates as the member approaches Normal Retirement Age. This is commonly known as ‘lifestyling’, with the main purpose being to reduce volatility and investment risk, as you get closer to your retirement.
 
Your money purchase ‘pot’ will rise (or fall) in line with the return on each of the individual investment funds where your contributions have been invested. Depending on the value of your investments the scheme administrator will work out how much pension the money in YOUR ‘pot’ can purchase.
 
Depending upon how your pension scheme operates, you will be given a menu from which you can select benefits to suit your personal circumstances, such as a spouse’s or civil partner’s survivors’ pension, a tax free lump sum, pension increases during retirement, for example.
 
If your defined benefit underpin provides a greater pension benefit than the pension benefits from your money purchase ‘pot’ then that is what you will receive.
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Why are interest rates important to me?
 
The amount of your pension from your money purchase ‘pot’ will greatly depend upon long term interest rates at the time you draw your benefits. These interest rates, which determine the cost of borrowing large sums of money by the Government and companies over the next twenty or thirty years, drive the cost of buying pensions. The higher that long term interest rates are, the more pension you will usually expect to get for your ‘pot’, although other factors such as investment returns and annuity rates are equally important.
 
A few very large employer sponsored money purchase schemes do not use annuities to provide members’ pensions but the terms they use to convert the ‘pot’ into a pension will be very close to the market rates offered by insurance companies.
 
Interest rates and annuity rates are less important in respect of any pension benefit that comes from the ‘defined benefit underpin’ element of your pension. Here, your pension benefit is linked to your pensionable service, pensionable salary and the formula used to calculate those benefits. The cost of the ‘promise’ could however eliminate any choice you might have in deciding how you want your benefit to be paid.
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What are my benefits worth?
 
Money purchase ‘pot’
 
The value of your ‘pot’ can readily be given to you by the scheme administrator but its value will go up (but may also go down) with time.
 
Your pension benefits at retirement which result from your ‘pot’ cannot be precisely determined in advance, as they depend upon investment conditions up to the date you retire.
 
If you want to investigate this further, you should consult an independent financial adviser if you are planning any changes in what you are trying to achieve.
 
Defined benefit underpin
 
You may know what your defined benefit underpin will provide if this was spelled out when you joined the pension scheme. If your underpin benefits are based upon a formula such as one that contains your pensionable salary, the number of years service in the scheme, and an ‘accrual rate’, this can only provide an approximate figure of what to expect at retirement. Under these circumstances, until the final calculation is made at the time you are due to take your benefits, any other figures you receive will be just an estimate.
 
For this you should seek the assistance of a specialist financial adviser with specific experience of money purchase schemes with a defined benefit underpin.
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Are my benefits secure?
 
Your money purchase pension benefits are as secure as the investments of the investment funds in which the contributions are invested. The larger the investment fund and the more reputable the investment manager, the less likely the funds are to lose all their value.
 
The wider the range of investments which the fund holds, the less they will move up and down. Some funds like commodity funds, hedge funds or emerging markets can be highly speculative so values can rise and fall sharply.
 
Investment markets will rise and fall, so it isn’t possible to estimate with any accuracy the amount of benefit you will receive until quite close to your retirement.
 
In the event of the sponsoring employer going into receivership, if the scheme does not have sufficient funds to pay all benefits, it is possible that the scheme might qualify to join the Pension Protection Fund. This would provide a limited ‘guarantee’ but could still mean a significant reduction in your benefits.
 
After you retire, your benefits will usually be secure.
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What is meant by ‘investment risk’ and ‘mortality risk’?
 
In an employer sponsored money purchase scheme, the fact that your future pension benefits will depend upon the value in your ‘pot’ at retirement, means that you may be exposed to ‘investment risk’ through weak investment performance.
 
You will also be exposed to a degree of ‘mortality risk’. Mortality risk is the likelihood that you will die at any given time. Evidence reveals that people are living longer in retirement. The effect of people living longer and so drawing their pensions for longer than expected, means pensions are becoming more costly. The longer this trend continues, the less your pension ‘pot’ will produce in terms of actual pension income at retirement.
 
The sponsoring employer carries both the investment risk and mortality risk in respect of the whole of the defined benefit underpin element of your pension benefits.
 
See what your Life Expectancy is.
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Can my benefits and contributions be changed?
 
Any changes in pensions legislation might mean that the scheme has to change.
 
Sometimes a scheme will change to another form of scheme, or perhaps the investment options will be reviewed. In this situation, you should be given full details of all intended changes.
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What rights do I have as a member to ensure the scheme is run properly?
 
If the scheme operates with Trustees, any member can seek election to become a Trustee. A Trustee is responsible for ensuring the scheme operates within the pensions law.
 
If you are unhappy about any aspect of the scheme, contact the scheme administrator or your employer. If they do not satisfy you, you can contact The Pensions Ombudsman or The Pensions Regulator depending on your problem. Also, see our list of Useful Contacts.
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Summary & Key Points
 
A defined benefit arrangement is a scheme which is financed by the sponsoring employer (except for some Public Sector schemes); the benefits are calculated shortly before you draw them (e.g. at Normal Retirement Age, Early Payment) using a formula including final pensionable salary, length of pensionable service and accrual rate.
 
A money purchase (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. 
  • Keep informed. Your scheme may modify benefits and 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 money purchase scheme with DB underpin v3.0 Active
Last updated 15/01/2007
 
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Glossary
View our Glossary for definitions of the terms used in our Factsheets
 

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What is a MP Scheme with a DB Underpin - Active Members
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