What is a money purchase scheme with a defined benefit underpin? Pensioner 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 pensioner members of a money purchase scheme with a defined benefit underpin.
Introduction
This Factsheet takes a 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?
What is a money purchase scheme with a defined benefit underpin?
In its simplest format, a money purchase scheme with a defined benefit 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 ‘money purchase ’ element of the pension scheme
- a ‘defined benefit’ 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 money purchase scheme?
A ‘money purchase scheme’ provides benefits based upon the amount of money that was in YOUR own ‘pot’ when benefits were due to be paid.
The amount that was in your ‘pot’ when benefits arose will have depended upon the payments made into your ‘pot’, the investment return achieved on each individual payment to the pot, and any costs which were charged against your growing ‘pot’. The benefits you or your dependents get from a money purchase scheme 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 have paid into them on your behalf). None of these provides an alternative benefit.
Summary
In an employer sponsored money purchase scheme your ‘pot’ will usually have consisted of -
- employer contributions plus
- YOUR contributions plus
- investment returns less
- charges
What was in your ‘pot’ at retirement will have been used to provide you with your pension benefits.
What is a defined benefit underpin?
Most ‘defined benefit underpins’ provides YOU with 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 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.
Example:
Jennifer Grant is a preserved member of her pension scheme. She changed employer and ceased to be an active member of the pension scheme in January, 2004. She will receive a pension from her former employer’s ‘money purchase scheme with a defined benefit underpin’ at her normal pension age, 65.
She was a member of the scheme for 20 years and her final pensionable salary when she left in January, 2004 was £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 preserved pension from the ‘defined benefit underpin’ at the date she left the scheme was:
20 years x £30,000
120
= £5,000 p.a.
This ‘defined benefit underpin’ preserved pension will receive increases to it (called ‘revaluation’), between the period that the left the scheme in January, 2004 and her 65th birthday, her normal pension age.
At retirement, if the pension benefit from her ‘pot’ in the money purchase element of her pension produces less than the defined benefit underpin, Jennifer will receive her pension from the ‘underpin’ element of the pension scheme.
If the pension benefit from her ‘pot’ in the money purchase element of her pension produces more than the defined benefit underpin at retirement, then Jennifer will receive her pension benefits from that instead.
The Trustees will have looked 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 have received the higher of the two.
Some calculations can be very complex and involve other factors as well as those mentioned above.
When could I have got my pension benefits?
Benefits will normally have been paid to you when you reached your scheme’s normal pension age or Normal Retirement Date. This is important as it is the date at which you would normally have been 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 have been entitled to receive benefits at other dates such as:
- Early retirement,
- Retirement due to ill health,
- Terminal illness, or
- Late retirement (where you choose to work beyond normal pension age).
How secure are my benefits?
Before you retired, your money purchase benefits were as secure as the investments of the investment funds in which the contributions were invested. The larger the investment fund and the more reputable the investment manager, the less likely the funds were to lose all their value.
The wider the range of investments which the fund held, the less they will have moved up and down. Some funds like commodity funds, hedge funds or emerging markets can be highly speculative so values can rise and fall sharply.
The defined benefit underpin will only be 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 particularly where your pension is being provided through an annuity policy.
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.
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.
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 Pensioner
Last updated 15/01/2007
