What is a Defined Benefit Pension?

My dad has a defined benefit pension. It seems having a final salary pension means he’ll never run out of money in retirement, no matter how long he lives. Is this the case? Which companies offer defined benefit pension plans and can I join one?

Question asked by Ms I Goodman
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Answered by Michael Englefield

  

What Does a Defined Benefit Pension Mean?

It’s fairly simple to explain defined benefit (DB) pensions. They’re pension plans where the benefit you’ll receive (plus any inflationary increases over time) is defined on your date of retirement.

There are two types of defined benefit pensions:

  • final salary pension is a pension where your post-retirement benefit is based on your salary at retirement
  • career average defined benefit pension is a pension where the post-retirement benefit is based on the average of your salary across your career with that employer.

DB schemes are often called final salary schemes, but the terms aren’t technically interchangeable – final salary schemes are actually a type of defined benefit scheme. However, as final salary schemes are the best known the name has tended to stick!

 

How Do Defined Benefit Pensions Work?

You’re right in that your father’s pension won’t ever technically run out of money.

What is a defined benefit pension?

A defined benefit pension works by building up an entitlement to a retirement income throughout your working life rather than an actual pot of retirement savings to live off.

That means a defined benefit pension plan is essentially a promise from your employer to pay a pension for life and not a finite pot of cash, as with a defined contribution pension plan.

At retirement, the defined benefit pension fund promises to pay the employee (i.e. your father) a guaranteed income for the rest of his life, which will usually be indexed to prevent his income being eroded by inflation.

 

Which Companies Offer Defined Benefit Pensions?

The bad news is that final salary pensions are workplace pensions set up by your employer; you won’t be able to get one of these by yourself. Your employer must offer a defined benefit pension scheme – and one that is still open to new members – as this is the only way to get a defined benefit pension.

how do defined benefit pensions work?

Very large employers and the public sector are the only real source of DB pension plans these days – and even some of those are closing their doors to new members.

As people live longer, the promise to pay out indefinitely has become expensive, so companies are worried about defined benefit pension affordability and under-funding.

 

work out how much your DB pension is worth

Calculating Final Salary Pensions

The income you’ll get from a defined benefit pension is based on three factors:

  • number of years you’ve been working for that employer and contributing to their pension scheme
  • your pensionable earnings (for final salary schemes, this is your salary at retirement; for career average schemes, this is your mean salary across your career)
  • your pension scheme’s accrual rate (the proportion of your earnings you’ll receive for each year spent in the scheme, usually represented as a fraction, e.g. 1/80th).

The common calculations for working out how much your defined benefit pension is worth are below.

Defined Benefit Scheme Calculation

Number of years in scheme

33 years

Pensionable Earnings

£60,000 final salary

Scheme accrual rate

1/80th

30 years * £50,000 * 1/80th
An annual income of £24,750

 

Can I leave my final salary pension scheme?

You can do a defined benefit pension transfer to leave your final salary scheme, but you must think carefully before doing so. You’ll be giving up the promise of a lifetime income, which should never be taken lightly.

However, you don’t have to stay in your pension scheme and leaving is possible. In fact, now may be a better time to do so than in the past.

defined benefit pension transfers

Given final salary pensions are an expensive long-term promise, many pension funds are offering attractive cash equivalent transfer values to encourage members to leave the scheme in exchange for a pot of cash.

This is in the wake of recent economic shocks that have impacted DB pension plans’ ability to achieve a return on investment.

To discover more on what today’s high CETVs mean for your final salary pension, click here. If your father has received a CETV and wants to know whether his offer is good value he can use our Defined Benefit Pension Transfer Calculator.

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Final salary pension
 
Defined benefit pension
 
This information does not constitute financial or other professional advice. You should consult your professional adviser or contact us directly on 02084327333 should you require financial advice. It is important to ensure any insurance policy you take out is suitable for your needs.
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