Retirement fund choices may confuse you. Today we explore defined benefit funds, with pointers on their pros and cons. The next two articles in our Scrapbook series will feature defined contribution pension funds and defined contribution provident funds.
A defined benefit retirement scheme is exactly what the name implies; you are guaranteed a benefit (a pension when you retire) at a predetermined value or income level.
On your first day at work you can virtually work out the pension you will receive when you retire, based on how much you are likely to be earning when you retire.
For many years defined benefit funds were the main form of retirement savings, if you were employed.
However, defined benefit funds are fast-becoming a thing of the past, particularly in the private sector.
In the 1980s trade unions, seeing the immense amount of wealth being controlled by employers, agitated for a move away from defined benefit schemes and towards defined contribution schemes, which would give union members greater control over their retirement funds.
Initially, this move was opposed by employers, who thought that unions would be irresponsible in investing the money.
But two things happened: on the whole, the unions proved to be very good at handling retirement money; and employers realised that they had been carrying all the risk with defined benefit funds, and were only too happy to be relieved of that risk.
The move away from defined benefit schemes gained further impetus when, after years of solid investment performance, many pension funds built up significant surpluses, that is, more funds than necessary to cover the defined benefit levels. The one way employers could get their hands on the surplus funds was to encourage employees to move to defined contribution funds (which we look at in part 22 of the Scrapbook series).
Prior to legislation on the distribution of surpluses, which was approved last year, the best way for employers to get hold of a portion of the surplus was to encourage members to move to defined contribution funds, taking some of the surplus with them.
In most cases, both you and your employer contribute to a defined benefit fund, but your employer has to pay you a pension at a predetermined level when you reach retirement age.
If there is not enough money in the fund to meet your pension, your employer must cough up. You are not required to pay in extra. This means that all the risk of ensuring that you receive the pension promised to you lies with your employer.
How much does it cost?
Normally, both you and your employer contribute to a pension fund, but your employer is not obliged to contribute any fixed amount.
The amount you contribute is worked out as a percentage of your salary, because the pension you receive will be a percentage of your salary when you retire.
Most schemes operate on the basis that both you and your employer contribute to the pension fund. Your employer's contribution is generally equal to your's. However, in the past, many employers took "contribution holidays" (that is, they did not make contributions) while the fund was in surplus. In terms of the new legislation on surplus distribution any employer who took a "contribution holiday" must now pay into the fund the money they should have contributed during the "holiday".
The amount you and your employer contribute is a fixed percentage, normally about six percent, of what is called your pensionable salary, which excludes special allowances such as motor car allowances.
As your salary increases, so will the actual rand amount you and your employer contribute, but the percentage remains constant.
How is a defined benefit pension calculated?
The pension you receive is worked out using a formula that includes your salary at retirement (this is often the average salary of your last two or three years of service), the number of years of service (or, more precisely, your period of membership of the retirement fund), and a factor that is based on a percentage of your salary at retirement, normally between one and two percent.
Here is an example:
Average monthly salary for last two years: R12 000 (R144 000 a year)
Length of service: 30 years
Percentage of annual salary for each year of service: 2 percent
Calculation: 30 x 2 = 60 percent of final average salary
Pension equals: R86 400 a year, or R7 200 a month
However, on retirement, you are allowed to take a maximum of one-third of your pension as a lump sum cash payment.
This is called a commutation.
The formula for calculating this one-third commutation varies from fund to fund and takes into account your age at retirement, a commutation factor representing the average life expectancy of fund members beyond retirement, and the value of the underlying assets in the fund.
Based on the same figures as the above example, you would calculate the one-third lump sum as follows:
Annual pension: R86 400
Age at retirement: 65
Factor of commutation: 9
Total value: R86 400 x 9 = R777 600
Therefore your one-third commutation would be a lump sum of:
1/3 x R777 600 = R259 200
If you commute the full allowed amount, your monthly pension is then reduced by one-third.
This is how it works:
Annual pension: R86 400
Less one-third: R28 800
Final annual pension: R57 600
Monthly pension: R4 800
The Advantages of a defined benefit scheme
The advantages for members are:
- You do not take the investment risk. In other words, you know what you will receive when you retire. If investment markets collapse, your employer has to make up any shortfall to meet your promised pension;
- Your monthly contributions are tax deductible. Tax is deferred until you receive the benefits. In other words, you can deduct your contributions to a defined benefit retirement fund from your annual income before the tax on it is calculated.
The pension fund pays tax at a rate of 18 percent on any interest, foreign dividends and net rental it may receive from property investments.
When you retire, any lump sum you take (after an initial tax free amount) is taxed at your average rate of tax, rather than the harsher marginal rate. Normally a maximum lump sum of R120 000 is tax free. You should always commute at least this portion because of the tax advantage.
Your monthly pension, paid from the remainder of the money, will be taxed at your marginal rate of taxation; and
- Your family will probably be better off if your die. Likewise you will probably be better off if you have to take early retirement because of ill-health, particularly when you are younger.
The reason for this is that you, or your family, will receive a pension based on what you could be expected to earn at your normal retirement age. Here is an example of a pension paid out after death or disability:
Normal retirement age: 65
Death or disability at age: 40
Years of past service at early retirement due to death or disability: 10
Number of years taken into account for calculating your pension benefit: 10 + 25 = 35 years
Your group life and disability assurance benefits also need to be taken into account.
With a defined benefit retirement scheme, if you are disabled or die, the company's life and disability scheme normally pays out about twice your annual pensionable income at the time of your early retirement.
The disadvantages of a defined benefit scheme
The disadvantages for members are:
- There are seldom guarantees that your pension payments on retirement will keep up with inflation. Increases are normally dependent on the excess investment income of the fund. The decision whether to increase pensions is taken by the board of trustees of the fund. In most cases, pensioners are awarded increases of about 75 percent of the inflation rate every year. This means pensioners get progressively poorer. However, in terms of the new legislation, if your fund is in surplus the first claimants on the surplus are pensioners whose pensions have not kept up with inflation. If there is sufficient surplus, their pensions going back to 1980 must be brought into line with inflation;
- When a member dies, the surviving spouse may be paid up to 40 percent for a surviving spouse; and
- There is no obligation on the trustees to pass on a higher pension as a result of the fund's good investment performance. It is up to the trustees to decide whether to pass on some of the out-performance to you by way of benefit increases.
Pension transfers
Increasingly many defined benefit funds are "transferring" pensioner members to life assurance companies. In effect your fund buys a pension from the life assurance company with the funds that have been set aside for your retirement.
Many employers prefer this as it can, but does not always, remove the risk of your retirement fund not having sufficient funds to meet your pension. Another reason why employers like to transfer pensioner members to life assurers, is so that they are not responsible for the administration of the pensions. Normally the life assurance company provide guarantees on your pension as well as on increases in the future, depending on underlying investment performance.
Pension transfers can result in greater choice for pensioners, including the ability to purchase living annuities. If you buy a living annuity, your pension will not stop when you die, and payouts to your spouse will not be reduced. However, with living annuities you have to take the risk that you will have sufficient money to provide you with a pension until you die. You, may also, be better off in a living annuity if the underlying investments perform well, but this may not necessarily happen.
If you are given a choice as to the type of pension (called an annuity), you should get advice from a properly qualified financial adviser.
Part 22:
Defined contribution retirement funds