Retirement fund choices can confuse. Today, Bruce Cameron will explore defined benefit funds. In the next two Scrapbook series articles, he will look at defined contribution pension funds and defined contribution funds.
WHAT IS IT?
A defined benefit retirement scheme is exactly what the title implies, namely, you are guaranteed a benefit (a pension when you retire) at a certain level or income.
You can work out the amount you will receive when you retire on your first day at work.
For many years, defined benefit funds were the main form of retirement savings, if you were employed.
In the eighties, however, trade unions, seeing the immense amount of wealth being controlled by employers, agitated for, and succeeded in starting, a move away from defined benefit schemes, to defined contribution schemes, where the union members would have greater control over their retirement funds.
Initially, this move was opposed by employers, who thought that unions would be irresponsible in investing money.
But two things happened: the unions proved to be very good at handling retirement money; and secondly, employers suddenly realised that they were carrying all the risk with defined benefit funds.
In most cases, both you and your employer contribute to a defined benefit fund, but your employer has to meet a promise to pay you a pension at a pre-determined level on retirement.
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. So all the risk lies with your esteemed and beloved employer.
HOW MUCH DOES IT COST?
Normally, both you and you employer contribute, but your employer is not obliged to contribute any fixed amount. The amount you contribute is worked out as a percentage of your salary.
The reason for this is that the pension you receive will also be a percentage of your salary.
Most schemes operate on the basis of both your employer and yourself contributing equal amounts to the fund.
The figure is also normally about six percent of what is called your pensionable salary.
In other words, special allowances, such as motor car allowances, are not normally included. So as your salary increases, so will the actual amount you and your employer contribute increase. But the percentage remains constant.
HOW IS A DEFINED BENEFIT PENSION CALCULATED?
The pension you receive is worked out on a formula that takes account of 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, membership of the retirement fund) and a percentage of your salary.
HERE IS AN EXAMPLE
Length of service: 30 years
Average monthly salary for past two years: R10 000 (R120 000 a year)
Percentage of salary for each year of service: 2 percent
Calculation: 30 x 2 = 60 percent of final average salary
Pension equals: R72 000 a year, or R6 000 a month
However, on retirement, you are allowed to take a maximum of one third of your pension as a 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, the average expected date of death of all members, and the value of the underlying assets in the fund.
Based on the same figures as the above example used to calculate a pension, here is an example to calculate the one third lump sum:
Annual pension: R72 000
Age at retirement: 65
Factor of commutation: Nine
Therefore your one third commutation would be:
R72 000 x 9 = R216 000
The consequence is your monthly pension is then reduced by one third.
This is how it works:
Annual pension: R72 000
Less one third commutation: R24 000
Remaining annual pension: R48 000
Monthly pension: R4 000
ADVANTAGES OF A DEFINED BENEFIT SCHEME
* You do not take the investment risk.
In other words, you know what you will receive when you go on pension. If there is a collapse in investment markets, your employer has to find the extra money to make up any shortfall to meet your pension;
* Your contributions are tax deductible. Tax is deferred until benefits are received.
In other words, you can deduct your contributions to a defined benefit retirement fund from the tax you pay on an annual basis. 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. Your monthly pension is taxed at your marginal rate of taxation; and
* Your family will probably be better off if your die, or have to take early retirement because of ill-health when still employed, 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. An example of a pension paid out as a result of disability or death:
Normal retirement age: 65
Age at ill-health retirement: 40
Years of past service at early retirement: 10
Number of years taken into account for calculating your ill-health pension benefit: 35 years
The same length of service calculation is used for the benefit your dependants would receive if you died.
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 group life and disability scheme will pay out a maximum of twice your annual income.
DISADVANTAGES OF A DEFINED BENEFIT SCHEME
* 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;
* When the member of the fund dies, the pension is reduced by up to forty percent for the surviving spouse;
* You may not have the advantage of a higher pension as a result of good investment performance in the fund.
It is up to the trustees to decide whether to pass on some of the out-performance, by way of benefit increases; and
* If you change jobs, you may not be able to take more than your contributions and a nominal amount of growth on your contributions.
With the "job for life" concept virtually out of existence, this is an important factor.
