We often get asked by people whether they should stay in their defined benefit super scheme or move to defined contribution. The common belief is that you should never exit a defined benefit scheme. But is that always true?
The simple answer is that defined benefit schemes are becoming less and less attractive, although the preferred option will differ for each individual. Why not contact Lime Super and we can perform a free analysis for you.
What is a defined benefit scheme?
Defined Benefit (DB) schemes involve an employer paying a superannuation benefit upon an employee’s resignation or retirement based on a formula such as:
Benefit = X% x YOS x AS
X is a percentage, such as 15%
YOS is the number of years of service ie years of employment
AS is the Average Salary at the end of employment eg over the past 3 years.
These definitions all vary slightly from employer to employer however the principle is the same.
As an example, if an employee has worked for an employer for 20 years, has earned $100,000 for each of the past 3 years, and the scheme has a multiple of 15% then their superannuation benefit will be $300,000.
One thing you will notice about the formula is that it is based on salary over the past few years (eg 3 years). Your superannuation benefit can vary significantly based on what happens to your salary in the last few years of employment. Similarly, your future superannuation benefit is highly dependent on what salary increases your receive in the future.
DB schemes were typically offered by large companies and governments. Most scheme sponsors (employers) stopped allowing new members into the fund around 15 years ago. So members of DB schemes today tend to be those people that have worked for a large employer or government for over 15 years. If you aren’t already in a DB scheme it is probably too late to join so this article will be of academic interest only.
If you are in a DB scheme, however, you have an important decision to make – to stay or to move to Defined Contribution.
What is a defined contribution scheme?
Defined contribution (DC) schemes are also called accumulation schemes. They include Self managed Super, retail funds and industry funds. Typically an employer contributes a fixed percentage of salary (eg 10%). The minimum, called the Superannuation Guarantee, is 9% although this will increase to 12% over the next few years.
These contributions are subject to tax of 15%, and are invested within the superannuation fund.
As an example, suppose an employee started working 20 years ago, had a starting salary of $33,000 which has grown at 6% p.a. to $100,000 today, received contributions of 10% of salary, and earned 7% p.a. after tax and fees. That employee’s superannuation benefit now would be approximately $200,000.
The superficial comparison
This employee has clearly been better off, over the past 20 years, in the DB scheme. They would have $300,000 in super from the DB scheme, compared to $200,000 from the DC scheme.
There are 2 reasons why the DB scheme appears to be better, and are indeed better in the early years of someone’s employment
The annual percentage is higher. In the example above, the member’s benefit is increasing by 15% of salary each year in the DB scheme, compared to 10% in the DC scheme.
In a DB scheme, investment risk is taken by the employer. If share markets fall, that is the employer’s problem (as long as the employer can afford to make up the shortfall in the fund!). In contrast, members of DC schemes take on investment risk themselves. If markets fall then their investment balance reduces.
What happens when we dig a bit deeper
The superficial comparison above is backward looking. It compares what has happened over the past 20 years. And indeed the DB scheme has been better.
What is relevant now is what will happen in the future. The relevant question to ask is “Am I better off leaving my money in the DB scheme or moving it into a DC scheme such as a SMSF, based on what is likely to happen in the future”.
There is a key reason that the future is different to the past – the rate of salary growth. A 50 year old, for example, is less likely to receive large salary increases than a 30 year old. Once your salary stops growing, the rate of growth in your DB balance slows down significantly.
So let’s continue the above example and look at the next 5 years. Suppose the employee now expects future salary growth of 2% p.a.
If the member remains in the DB fund, then their balance in 5 years will be $414,000. However, if they move across to a DC fund, their projected benefit will be $476,000. That is an extra $62,000 over 5 years. So in this case the member would be far better off switching to a DC fund such as SMSF.
Are defined benefit funds Safe?
The answer to this question depends on the specific fund, and the financial ability of the employer to increase contributions in the event of poor investment earnings. Most funds are safe, although this cannot be guaranteed for all funds. This position could change if we saw a combination of a severe economic downturn coupled with negative share market returns.
So what is the right answer for you?
Of course that depends on your personal circumstances. As a general rule, DB schemes are better suited to people with the following characteristics:
Younger than 40-45
Expecting large salary increases in the next 3-5 years (eg 5-10% p.a. or more)
Worked for their organisation for less than say 15 years.
Ironically, less and less members of DB schemes fall into these categories as those members get older. So if you are a member of a DB scheme then it is probably time to review your situation.
Please contact us at Lime Super on (02) 8096-5901 for a free comparison of Defined Benefit versus Defined Contribution tailored to your personal circumstances.
General Advice Warning
The information in this article is general in nature and is not tailored to your personal circumstances. You should speak to a qualified professional such as your financial adviser before acting on this information.