Defined benefit pension schemes are seen as the gold standard of retirement savings. Also known as final salary pensions, they provide guaranteed income for the rest of your life — usually index-linked to maintain pace with inflation — based on your salary, the length of time you were in the scheme and the scheme’s accrual rate.
Such pensions tend to be offered larger organisations and the public sector only. They were once more common, but the cost of providing such guarantees has proved expensive, resulting in many schemes closing to new members or even going bust.
Although both you and your employer pay into the pension fund during your years of service, there’s no actual pot of pension cash with your name on. Rather, it’s a promise from that pension fund to pay you a retirement income.
The benefit you’ll receive is defined at your date of retirement rather than by how much you’ve managed to save over your working life.
Defined benefit pensions are sometimes referred to as final salary pensions because final salary pensions are the best known type of defined benefit pension.
However, the two terms aren’t technically interchangeable — in reality, a final salary pension is a type of defined benefit pension.
There are two types of defined benefit pension, based on either:
Whether you have a final salary or a career average defined benefit pension, they’re both essentially a promise from a pension fund controlled by your employer to pay you an income for the rest of your life.
Both you and your employer pay into a defined benefit pension the same way that you and your employer would pay into a money purchase (or defined contribution) scheme.
However, instead of those funds going towards a pot of cash with your name on that you turn into a retirement income — usually by purchasing an annuity or entering income drawdown — a defined benefit pension has no specific pot of cash in your name.
It is simply a promise to pay you a retirement income until you pass away. Your contributions go into a defined benefit pension fund and, when you retire, that fund pays you an income, which is taxable at your highest marginal rate of income tax.
The counterpart to a defined benefit pension is a defined contribution pension or money purchase pension. This is the type of pension most people are now saving into, especially those recently captured by auto-enrolment.
The main difference is that defined contribution pensions are a pile of cash you build up during your working life, whereas a defined benefit pension is a promise from an employer’s pension fund to provide you with an income from retirement until you pass away.
There’s no guarantee of an income with a defined contribution pension, unless you use it to purchase an annuity.
How much your final salary pension is worth at retirement depends on three factors:
Calculating Defined Benefit Pension Value at Retirement | |
|---|---|
Years in scheme | 25 years |
Pensionable earnings | £65,000 final salary |
Scheme accrual rate | 1/80th |
25 years * £60,000 * 1/80th An annual income of £18,750
| |
Most schemes have a normal pension age of 65, which means you’ll have to be 65 before taking a your final salary pension. A few schemes may allow you to take benefits as early as 55, but this could significantly reduce the amount you get.
If you want to work past your defined benefit pension’s normal retirement age, you may be able to defer claiming your pension. Alternatively, with some pension plans they may allow you to take your pension without retiring.
All of these factors are up to the discretion of the scheme administrator and your individual pension fund’s rules, so there’s no hard answer as to when you can take your defined benefit pension.
When you retire, you can technically receive up to 25% of your defined benefit pension savings tax-free. However, it’s important to realise that taking a defined benefit pension lump sum will reduce your annual pension benefit.
The monetary impact of taking a lump sum from your defined benefit pension is complicated to work out. It depends on what’s known as your pension fund’s commutation factor, which represents how much of a lump sum you’ll receive for every £1 you give up in income. A commutation factor of 10 means you’d receive a lump sum of £10 for every £1 of final salary annual income you choose to sacrifice. You will need to contact your pension scheme administrator to find out what yours is.
Final salary pension transfers are possible. This sees you leave your defined benefit pension scheme in exchange for a pot of cash invested in a defined contribution pension.
A final salary pension transfer is unlikely to be in the interests of most people, but for the minority for whom it is an option, a transfer means you then have all of the benefits associated with having a defined contribution pension following the introduction of the April 2015 pension freedoms. Of course, along with those benefits comes the downsides to no longer having a defined benefit pension, such as the loss of a guaranteed income for the rest of your life for you and typically your spouse.
A cash equivalent transfer value or CETV is the technical term for the lump sum you’ll be offered to leave your pension scheme and cut ties with the plan for good, forfeiting the right to any future income from the scheme.
The pension transfer value you receive will vary depending on your employer and a variety of other factors, so it’s essential to ensure you’re getting a good CETV before going ahead with a pension transfer. If not, then it may not make financial sense to transfer at all.
Use our Final Salary Transfer Calculator below to find out if an existing CETV you have is a good deal, or find out what a good CETV might be depending on the size of your annual benefit.
For public sector workers in unfunded pension schemes, it’s only possible in the rarest of circumstances to transfer out of your defined benefit scheme. It’s not possible to transfer the vast majority of public sector final salary pension schemes.
The exception may be if you’re transferring to another defined benefit scheme, particularly if it’s another unfunded public sector final salary scheme, but again this is very rarely permitted.
This is because public sector pensions have no fund behind them — they’re a promise from taxpayers.
The local government pension scheme is different because this is funded — you may be able to transfer out but, as with any final salary pension transfer, you’ve got to consider your options carefully to make sure it really is the best thing for you.
Historically, people tended to have a job for life. They’d work for a single employer throughout their working life and then retire. Here it made sense for employers to manage the pension fund on behalf of their employees.
However, today people change jobs more frequently and therefore may build up entitlements in several pension schemes, both defined contribution and defined benefit.
If you’ve left a company with a defined benefit pension scheme before you were due to retire, then your scheme administrator should have offered you a pension statement showing you how much benefit you’ve built up during your time in the scheme.
To compensate for the effects of inflation, this will generally be revalued every year.
If you’ve lost touch with your previous scheme administrator, consider tracing your lost pension. You can do this for free using the government’s free pension tracing service, or read more about how to find lost pensions here →
When you leave a final salary scheme you are giving up a guaranteed income for life. You can’t undo a transfer, so you need to think carefully whether this is in your best interests.
A pension transfer makes you responsible for investing your pension and you’ll bear the brunt of any investment losses, which means your income could fluctuate in line with the markets.
You’ll also need to consider your future retirement needs, including factoring in your life expectancy.
If you only have a small defined benefit pension and you transfer it to a defined contribution scheme, you may find that with an option such as pension drawdown your money runs out too soon.
To combat the risk of your income drawdown pension pot running out, we have put together a Pension Drawdown Calculator to show you how long your pension might last, including how long your pension would last if you transferred out of a defined benefit pension scheme.
However, there’s no guarantee that your pension will stay the course after you’ve transferred it, whereas a final salary pension is an income for life.
It’s mandatory to get advice if your final salary scheme is worth more than £30,000. At Drewberry we’ll take a look at your pension scheme and your circumstances and provide financial advice accordingly, recommending whether or not a final salary pension transfer is the right thing for you.
Neil Adams
Pensions & Investments Expert at Drewberry
IMPORTANT NOTICE 🧐
As of the Spring budget 2023, the UK chancellor announced the abolition of the pension lifetime allowance (LTA). This came into effect from 6 April 2023.
It’s important to note however, the Labour party has announced that if they were to be elected, the allowance may be reintroduced in the future. If this occurs, we will update our records to reflect any changes. The information on this page is based on the LTA pre 6 April 2023.
Final salary pensions were once common, in fact making up the majority of all pension plans. Yet today few companies offer defined benefit pensions. It’s mostly restricted to the public sector and very large private firms as these generous, gold-plated pension promises have become more and more expensive to provide.
In recent decades we’ve seen a swathe of DB pension funds beset with issues of affordability and closing their doors to new members.
Some defined benefit pension schemes have collapsed entirely and become wards of the Pension Protection Fund, which the government set up in 2005 to insure against this very risk.
Should this happen to your pension fund, you’re subject to a strict cap on what you can expect in retirement income no matter what you may have been entitled to before your fund collapsed.
With the public sector, the promise to pay DB pensions is usually made by central government. This is known as an ‘unfunded’ pension scheme because retirement income is usually paid to members out of general taxation rather than an actual pension fund. These include:
One big exception to public sector pensions being unfunded are local government pension schemes. Most local governments offer a funded DB pension plan, which means there’s a pension fund behind their promise to pay retirees.
A good financial plan can help you make the right decisions when it comes to your finances. Make the right decisions today to build a more prosperous future.
Good financial planning with clear goals can increase your retirement income by as much as 53%. Old Mutual Redefining Retirement Survey
We started Drewberry because we were tired of being treated like a number and not getting the service we all deserve when it comes to things as important as planning our finances. Below are just a few reasons why it makes sense to let us help.