Don’t take it personal

Financial worries or just looking for better value for money? Consumer champion Fergus Muirhead answers your questions A Why you can’t cash in your council pension under the new rules

QYOU recently stated: “If you have a personal pension then you can, from the age 55, take up to 25 per cent of the value of your fund as a tax-free lump sum.”

Simply, can I ask, why does the recent personal pension law change not seem to apply to my Local Authority personal pension? Ivor Davies THE very short answer is that the recent pension freedom changes only really applied to personal pensions, and your Local Authority Scheme is a defined benefit arrangement and so wasn’t affected by these changes. Also, it has always been possible to take tax-free cash from personal pensions, and from occupational schemes, but the ways in which the amounts are calculated are different, and I’ll explain this in more detail in a second. I’m having lots of conversations at the moment with people who are confused about the differences between defined contribution pensions and defined benefit pensions (broadly, personal pensions and company schemes) so I’m going to go back to basics today – and next week – and explain the differences between the two. The main difference between a defined benefit scheme and a defined contribution scheme is in the way benefits are paid. With a defined benefit scheme, the pension you receive is likely to be based on the salary you had when you were employed and your length of service.

Defined benefit schemes can either be ‘final salary’ or ‘career average earnings’.

With a final salary scheme, your pension is based on a multiple of the salary you have on leaving and your length of service. So, if you retire at 60 with a salary of £40,000 and you have 30 years service where each year gives you 1/60th of your salary as a pension, then your pension would be 30/60th of £40,000, or £20,000.

If, on the other hand, it was a career average earnings scheme and you had two years service, one at £10,000 salary

Fergus is here to help

and one at £20,000 salary, then your pension would be 2/60ths of £15,000 or £500 per annum.

Many public sector schemes have changed from final salary to career average earnings recently and you may have benefits in both parts of the scheme.

The rate at which you can accumulate benefits varies from scheme to scheme. Many schemes will have a factor of 60ths, others will be 80ths and some really good schemes will allow you to build benefits at a rate of 1/50th for each year’s service, or even 1/40th.

Your question was about tax-free cash and it is possible to take some of your benefits from a defined benefit scheme as a tax-free lump sum. With some defined benefit schemes, the tax-free cash is calculated on top of the annual pension. With others, some of the pension has to be converted into cash, leaving you with a lower annual income. You need to know which type of scheme you have to calculate accurate benefits. As a rough rule of thumb the tax-free cash might be three times the annual pension.

You also need to know how your pension increases after you start to receive it. Most defined benefit scheme pensions will increase each year in line with inflation, sometimes to a maximum figure of say three or five per cent. Some may be fully inflation linked.

You will also need to know normal retirement ages under the scheme rules. Some schemes have fairly large penalties if you try to retire earlier than the scheme retirement age, and these penalties could reduce your annual pension by as much a six per cent per annum.

The other issue you need to look at with final salary schemes is that of a dependent’s pension. Not all defined benefit schemes have the same rules when it comes to paying a pension after your death and you will need to understand how your children and partner will be looked after if you die.

The majority of the cost of defined benefit schemes is picked up by the employer, or the taxpayer in the case of some of the bigger public sector schemes. You, as the employee, will pay a fixed percentage of income and your employer will pay the rest. This is often a significant amount of money. Defined benefit schemes generally represent good value for money and if you have the chance to join one, you should take it.