Public sector pensions don’t always work well for lower paid employees. The pension flexibilities announced in the Budget could make a defined contribution pot a more attractive option
The introduction of new pension flexibilities in this year’s Budget has been widely welcomed and, as the dust begins to settle, we are beginning to understand the implications of the changes and starting to question past understanding about funding for retirement.
Whilst the new found flexibility to take pension benefits in a lump sum format (subject to payment of the relevant marginal rate tax) will not be suitable for everyone, it will certainly need to be seriously considered when funding or drawing benefits. What has also emerged under these and other recent reforms of pension legislation is that defined benefit (DB) pension schemes, often seen as the Holy Grail of public sector perks, may not necessarily always be the best option for some lower-paid workers and those wishing to draw their pensions early.
Employees who chose to draw their benefits early, often just to access the tax-free lump sum amount, could find themselves in a better position by having access to an alternative defined contribution (DC) pot. This could be drawn in cash and used to retire early without reducing the value of their main benefit. Individuals would continue to benefit from valuable employer contributions and accrue additional benefits whilst avoiding significant early retirement adjustments. This additional DC pot could also be used to fund the loss of scheme pension or state pension given the introduction of a later retirement age.
If this fund was not available when early retirement was necessary, further contributions could continue to be made to supplement this pension, something that would have been deemed unattractive before as it would have meant that the individual would have only had the option to draw a small annuity. For example, building up a £10,000 fund under the old regime might only have resulted in an annual pension of about £500 whereas many people would find the option of being able to draw £6,000 to £10,000 in lump sum cash (dependent upon tax rate) considerably more attractive, especially given the prospect of being able to pass this on to subsequent generations tax efficiently.
Lower earning public sector employees also need to consider whether participation in a DB scheme is right for them. The introduction of the new flat rate state pension at around £7,500 per annum means that an individual earning £15,000 a year would already have 50% of that fully pensioned. Were they to participate in a local government scheme this could build up to a further two thirds of salary on top dependent upon age and service (i.e. about 120% of salary). Some individuals already participating in the scheme may want to look more closely at their options. While the option of a DC alternative does not currently exist for public sector employees, it will for many admitted bodies. Take-up rates in public sector schemes, while high, highlight that the current solution is not universally attractive and these new flexibilities are likely to increase demand for such schemes to provide staff with access to a DC option.
Individuals will now not only need to consider the pension which would be provided but the contributions, the taxation position, how much benefit would be available in lump sum format and the relationship between pensions for couples, to name but a few. No wonder the government has recognised the need for members to receive advice at retirement on their options, although you have to question if this will be soon enough.
Pension schemes and employers need to consider how they deal with the new flexibilities members are likely to require and how these complex options are effectively communicated to staff.
David Davison is a director at actuarial firm Spence and Partners
