General principles: arrangements: money purchase and defined benefits arrangements
Paying authorised benefits rules - defined benefits and money purchase
How a registered pension scheme can provide authorised benefits to its members depends on whether the scheme provides benefits on a money purchase or defined benefits basis. The various pension rules and the lump sum rule apply differently depending on whether benefits are provided on a money purchase or defined benefits basis.
The legislation draws a distinction between money purchase arrangements and defined benefits arrangements when dealing with the rules governing the actual payment of benefits. This is because:
- a cash balance arrangement is also a money purchase arrangement, and once the benefits come into payment it is no different from any other money purchase arrangement, and
- at the point the benefit rules come into play, a hybrid arrangement will be treated as a money purchase arrangement or defined benefits arrangement, depending on the benefits actually provided.
So at the point benefits come into payment or entitlement arises under an arrangement that arrangement will always be treated as either a money purchase arrangement or a defined benefits arrangement.
Defined benefits arrangements
Sections 152(6) and (7) Finance Act 2004
As the name suggests, a defined benefits arrangement is one where the level of benefits payable is calculated by reference to the member’s earnings, length of service with the employer or any other similar factor other than the amount available to provide benefits.
Though contributions might be made to a defined benefits arrangement, and so there may be a pension fund or pot, the benefits that may be payable are not calculated by reference to that fund or pot. Members know in advance what their entitlement will be if not the exact level of benefits.
Final salary or career average arrangements are common examples of defined benefits arrangements. The following are also likely to be defined benefits arrangements:
- Case A - Removal of an early retirement factor that increases member pension by £10,000 per year
- Case B - The granting of one added year’s pensionable service leading to an additional pension of £10,000 per year
- Case C - The purchase of added pension of £10,000 per year by a member contribution, or salary/bonus/redundancy lump sum sacrifice (possibly based on a scheme table).
- Case D - The payment by a member of an AVC of £124,500 on the pre-arranged basis that this will grant the member additional pension of £10,000 per year.
However, a fixed amount e.g. £100,000 that is to paid out on death but which has not been expressed in benefit terms, so might be paid in the form of either a pension or a lump sum is not a defined benefit but a cash balance benefit. This is because the form of the benefit will not be decided on until on or after the death so there is no defined benefit.
Money purchase benefits arrangements
Sections 152(2) and (4) Finance Act 2004
A money purchase arrangement is one where the level of benefits payable to a member is calculated by reference to a capital amount of money that is available to provide benefits to or in respect of the member at the point of entitlement (sometimes called the member’s ‘pot’). The term money purchase benefits includes cash balance benefits.
Under the pensions tax legislation a money purchase arrangement that is not a cash balance arrangement is known as ‘an other money purchase arrangement’.
The precise amount of benefits the member receives under a money purchase arrangement will not be known in advance as it will depend on what their ‘pot’ can provide at the time, which will in turn depend on factors such as:
- how much has been paid into the arrangement
- investment returns on the contributions
- prevailing annuity rates, for instance how much £X will buy as an annual pension.