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Our expert compares rules for defined benefit and defined contribution schemes
Thursday 15 Jul 2021 Author: Tom Selby

Do defined benefit scheme members really benefit from a higher lifetime allowance than defined contribution savers? If so, how can this possibly be justified?

Tom Selby, AJ Bell Senior Analyst says:

The current lifetime allowance is £1,073,100 – a figure which will not change for the rest of this Parliament following chancellor Rishi Sunak’s decision to freeze the limit at the March Budget.

Because defined benefit members build up a right to a retirement income rather than a pot of money, a multiplier is used to convert their income entitlement into a notional fund. This is then tested against the lifetime allowance when the person starts receiving their pension.

This multiplier is set at 20, meaning whatever income a defined benefit member is entitled to at their normal pension age – the date their pension becomes payable – is multiplied by 20 to give a figure which is tested against the lifetime allowance.

If, for example, a defined benefit member received an inflation-protected pension income of £20,000 a year from their scheme, for the purposes of the lifetime allowance this would be multiplied by 20 to give a notional fund value of £400,000.

The maximum income someone in a defined benefit scheme could take without breaching the lifetime allowance is therefore £53,655 (20 x £53,655 = £1,073,100).

Defined benefit schemes usually offer to pay at least half of their guaranteed income to their spouse when they die (often referred to as a spouse’s pension). If the member receives a tax-free lump sum from the scheme, then this will be added to the notional fund value for the purposes of calculating how much lifetime allowance they have used.

Defined contribution savers have a pot of money which is tested against the lifetime allowance when they turn it into an income.

With a fund worth £1,073,100, someone could buy an annuity paying an inflation-protected income with a 50% spouse’s pension – roughly mirroring what a defined benefit member might expect to receive – worth just over £30,000*.

In other words, the effective available lifetime allowance is almost 80% higher for a defined benefit saver than their equivalent defined contribution counterpart.

The disparity exists because the lifetime allowance multiplier used to convert a defined benefit income into a notional fund is woefully out of date.

However, addressing what looks like an anomaly in the tax rules would likely create a huge row with the public sector – including doctors who have worked on the frontline during the pandemic.

There is therefore no guarantee that the Treasury will address this unfairness in the rules.

*Quote sourced from the Money Helper annuity calculator on 8th July 2021. Assumes annuity is bought at age 66 (state pension age) paying 50% spouse’s pension on death and rising each year by 3%.

Please note, we only provide information and we do not provide financial advice. If you’re unsure please consult a suitably qualified financial adviser. We cannot comment on individual investment portfolios.

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