Defined benefit and final salary pensions
By Paul Davies
Defined benefit and final salary pensionsLearn how defined benefit, or final salary, pension schemes pay you a retirement income. Work out how much you’ll get and the benefits of taking a lump sum.
A defined benefit pension scheme – sometimes called a final salary pension scheme – is one that promises to pay out an income based on how much you earn when you retire.
Unlike defined contribution (DC) pensions, the amount you’ll get at retirement is guaranteed, and it will be paid directly to you – you won't have to use your pension pot to decide your next move.
This guide explains how final salary schemes work and how you can work out how much income you could get in retirement.
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Final salary pensions – the different types
If you've saved into a final salary pension scheme, your savings, along with the contributions of your employer and the tax relief you receive from the government, have been invested in the stock market over your working years.
But the income you ultimately receive from your pension is a guaranteed, pre-agreed amount. This is why they are called 'defined benefit' pensions.
There are two types of defined benefit pension:
- final salary schemes, which are based on how much you're paid when you finally retire
- career average schemes, which are based on an average of your salary across your career.
Both types of pension provide valuable benefits, the biggest of which is something called 'index-linking'. This means that your pension income is guaranteed to rise each year so it can keep up with rising prices in the future.
This protection is usually capped at 2.5% a year, although, in some cases, it's linked to the Retail Prices Index (RPI) measure of inflation.
Other benefits of final salary pensions
Other benefits of final salary pension schemes include:
- death-in-service payments to spouses, partners or dependants if you die before reaching pensionable age
- full pension if you have to retire early through ill health
- reduced pension if you retire early, although this can’t be done before the age of 55.
Final salary pensions – how to work out your income
If you've saved into a final salary pension scheme during your career, it will provide you an income for your retirement based on three key factors:
- the number of years you have paid into the scheme
- your salary – this might be your final salary when you retire or your average salary across your career
- your pension scheme's 'accrual rate' – this is a formula that's used to calculate your final retirement income. This 'accrual rate' is a fraction of your salary (usually 1/60 or 1/80), and it’s multiplied by the number of years you’ve been in the scheme.
Let's look at how this works in practice:
- Your final salary when you retire is £30,000.
- You've worked at your company for 40 years.
- Your company uses an accrual rate of 1/60th.
- Your annual pension would be £20,000 (40 (years) x 1/60th (accrual) x £30,000 (final salary).
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Final salary pensions – taking a lump sum
When you retire, the government rewards you for saving into a pension by allowing you to take 25% of your savings completely tax-free. This is commonly called a lump sum, and taking it will reduce the amount of income you receive from your pension.
With final salary pensions, the way this is calculated is complicated. It's based on the scheme's 'commutation factor', which represents how much of a lump sum you get for every £1 you give up in income. So if you have a commutation factor of 12, you get £12 of lump sum for every £1 you give up.
You will need to contact your pension scheme to find out how much lump sum you will get from your final salary pension.
Go further: Should I take a lump sum from my pension? – weigh up the pros and cons of taking a lump sum
The decline of final salary pensions
Final salary pension schemes are advantageous for members because the scheme takes all the investment risk and is obliged to meet the 'pension promise' of a pre-defined amount of income made to each member, regardless of how underlying investments have performed. This means final salary pension schemes are riskier for employers.
Final salary pension schemes are also becoming more expensive as people live longer, because they have to pay out for longer. For these reasons, most private sector schemes have now been closed to new members and replaced by defined contribution schemes.
Go further: Defined contribution and money purchase pension schemes – get to grips with the other type of company pension
Protection for insolvent pension schemes
The open-ended nature of the ‘pension promise’ has left some pension schemes unable to meet future commitments. So, to protect members of insolvent employers where there is a shortfall in the pension scheme, the Pension Protection Fund (PPF) was established by the government to cover schemes that fail from April 2005 onwards.
The PPF ensures that:
- pensioners continue to receive the full amount due up to a cap of £36,401.19 at age 65
- others receive 90% of their expected pension – to a current maximum of £32,761.07 a year at age 65
- it is funded by a general levy on occupational salary-related schemes.
Useful link: Pension Protection Fund – learn more about how this fund works on its website.
- Last updated: December 2016
- Updated by: Paul Davies