Explaining Final Salary Pensions
The concept behind a defined benefit pension scheme is actually relatively simple to understand. It’s a pension where 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.
This defined benefit is based on your salary, your length of service with the company and the scheme’s accrual rate. It’s paid from a pension fund owned and managed by your employer.
Defined benefit pensions are sometimes referred to as final salary pensions because final salary pensions are the best known type of DB pension.
However, the two terms aren’t technically interchangeable – in reality, a final salary pension is a type of defined benefit pension.
How Do Defined Benefit Pensions Schemes Work?
There are two types of final salary pension, based on either:
- Your final salary – with a final salary pension your post-retirement benefit is based on your salary at retirement
- A career average salary – with a career average defined benefit pension the post-retirement benefit is based on the average of your salary across your career with that employer.
Final salary pensions are the better known of the two types of defined benefit pension, but whichever type you have 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 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.
Defined Contribution Pensions vs Defined Benefit Pensions
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.
Defined Benefit Pension Calculator
How much your final salary pension is worth at retirement depends on three factors:
- Length of service with your employer and how long you’ve been contributing to the pension fund
- Pensionable earnings at retirement (for a final salary scheme this will be your retirement salary; for a career average pension this will be an average of your annual earnings across your career with that employer)
- Your pension scheme’s accrual rate (usually represented as a fraction, e.g. 1/80th, this refers to the proportion of your earnings you’ll receive as a pension for each year spent in the scheme).
Calculating Defined Benefit Pension Value at Retirement
Years in scheme
£65,000 final salary
Scheme accrual rate
25 years * £60,000 * 1/80th
An annual income of £18,750
When Can I Take My Defined Benefit Pension?
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.
Can I take a lump sum from my final salary 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 effect 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.
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Can I Transfer Out of Defined Benefit Pension Schemes?
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. You then have all of the benefits associated with having a defined contribution pension following the introduction of the April 2015 pension freedoms.
What is a Cash Equivalent Transfer Value?
A cash equivalent transfer value or CETV is the technical term of the lump sum you’ll be offered to leave your pension scheme and cut ties with the plan for good.
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 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.
Can I Transfer Out of My Public Sector Pension?
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.
Benefits of Defined Benefit Pension Transfers
- Today’s transfer values that are being offered can be very high
Defined benefit pensions have become expensive to provide, especially in today’s economic environment. As such, funds are offering many scheme members high pension transfer values to leave the scheme and remove liability for that member from their books.
- Moving to a defined contribution pension provides more flexibility
The April 2015 pension freedoms mean a defined contribution pension is now a far more flexible retirement instrument. You can draw on it however you like, taking tax-free and taxable lump sums or deriving an income from it as you see fit. You can even split the fund, using some of it to purchase an annuity if you still wanted a guaranteed income.
- Grow you pension with future investment returns
You don’t benefit from future investment growth in your pension fund with a defined benefit scheme. That’s because your benefit is fixed at retirement, regardless of how well the underlying fund performs. If it the transferred defined contribution pension pot performs well, you may be able to afford to draw more income from it.
Risks of Defined Benefit Pension Transfers
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 interest.
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.
Even with an attractive transfer offer, the value of your pension and investments could fall as well as rise in line with market performance.
Although there are a number of rewards to be had from transferring a pension, the potential risks involved mean it’s important to seek pension advice. This is mandatory 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. To get an idea of what you can expect from a pension transfer you can use our final salary transfer calculator below.
Pensions & Investments Expert at Drewberry
Final Salary Pension Transfer Calculator
How good is your Final Salary transfer value?
Using our expertise we have modelled your results below so you can see what your final salary is likely to be worth as a single lump sum if you were to consider transferring out of the pension arrangement. Based on our experience and understanding of the transfers offered by various schemes we have created bandings based on what we would deem to be good value.
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These calculators help but sometimes it doesn't beat talking to a human. If you
need any support please do not hesitate to pop us a call on 02084327334.
Head of Pensions Advice at Drewberry
This calculation and additional information does not constitute financial or other professional advice. You should consult your professional adviser or contact us directly on 02084327334 should you require financial advice.
A transfer out of a final salary scheme is irreversible and can only be done after advice has been given by a qualified financial adviser.
The transfer value bandings we calculate should only be treated as guidance, your personal circumstances and other wealth must be taken into account to understand whether your pension transfer is good value given your specific situation. For more information on the assumptions made in this calculator please click here.
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What are the Pros and Cons of Defined Benefit Pensions?
- Guaranteed income for life
Defined benefit pensions promise an income from retirement to death, no matter how long you live
- No investment risk
Your annual benefit is guaranteed no matter how the underlying pension fund is doing (unless it collapses and becomes a ward of the Pension Protection Fund, although the PPF still pays you a pension in such a case)
- Inflation-proofed income
The guaranteed income you can expect is usually index-linked to keep pace with inflation
- Widows’/dependants’ pension
Many schemes pay a reduced widows’ pension or dependants’ pension to spouses/dependants of deceased pensioners
- Ill health pension
Some DB pension schemes won’t reduce your pension entitlement based on fewer years of contributions if you have to retire early due to ill health
- Enhanced income if you’re pensioned off due to ill health
Many DB Funds enhance your benefit post-retirement if you’re seriously ill to reflect the fact that they’ll likely be paying the pension for fewer years
- Potentially greater lifetime allowance protection
Pensioners face the pension lifetime allowance charge if they take benefits over £1 million. As there’s no pot of funds in your name, the lifetime allowance for DB pensions is calculated as 20 times your annual income, which may work out favourably compared to a DC scheme of a size that would provide a similar drawdown income to your DB pension income
- Beat the money purchase annual allowance
Once you start taking benefits from a money purchase pension, you’re restricted to making just £10,000 a year in future pension savings, a limit you’re not subject to when you start drawing a defined benefit pension.
- Risk from reduced life expectancy
Even if you are entitled to a higher pension due to ill health retirement, you’ll receive far less back from the scheme if you die soon after retiring than someone who’s paid in the same amount as you but lives for 20 years after retiring
- Your pension is a fixed income
Planning for tax with final salary pension income is tricky because there’s nothing you can do to alter it to minimise tax bills
- No flexible pot of cash to leave relatives
Benefits from a deceased pensioners’ final salary scheme are typically restricted to a reduced pension for spouses and dependant children under the age of 23, received it as a taxable income
- No inheritance tax benefits
There’s no inheritance tax to pay on a DC pension pot providing it’s still invested or in a drawdown fund, so it can be an incredibly tax-efficient way to pass wealth down generations
- No investment rewards
While there’s no investment risk with a defined benefit pension there’s also no room to benefit from investment rewards as the underlying investments aren’t yours. Your benefit stays fixed (apart from potential inflationary increases) even if the underlying pension fund sees bumper returns
- Your pension depends on the health of your employer
There have been a number of highly-publicised incidences of severely underfunded pension schemes at collapsed companies, with the most recent example perhaps being bankrupt department store BHS
- Retirement age is later
While you can access your pension at 55 with a defined contribution plan, scheme retirement ages for final salary schemes are typically set at or near state pension age.
Which Companies Offer Defined Benefit Pensions?
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.
There are currently over 5,500 defined benefit pension funds under the auspices of the PPF, the majority of which are in deficit.
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.
Public Sector Pension Schemes
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:
- NHS defined benefit pensions
- Teachers’ pension funds
- Army pensions (and other armed forces pensions)
- The police pension fund
- The civil service final salary scheme.
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.
Moving Jobs and Leaving a Defined Benefit Pension Scheme
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 pension tracing service, or read more about how to find lost pensions here →
Expert Defined Benefit Pension Advice
Final salary pensions are complicated, and the issues surrounding whether or not to remain in a DB pension or transfer out are not simple matters to consider.
Your scheme administrator should be able to answer many questions you have about your pension plan but they probably won’t be able advice. Drewberry provide holistic advice with regards to your financial circumstances including your defined benefit pension and the viability of transferring to a defined contribution arrangement. If you need some guidance give the team at Drewberry a call – we’re available on 02084327333.
Director at Drewberry