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Defined benefit and final salary pensions

Company pensions explained Defined benefit and final salary pensions

Defined benefit (DB) schemes offer more certainty than defined contribution (DC).

A defined benefit (DB) pension scheme is one that promises to pay out a certain sum each year once you reach retirement age.

This is normally based on the number of years you have paid into the scheme and your salary either when you leave or retire from the scheme (final salary), or an average of your salary while you were a member (career average).

How salary-related schemes calculate pension income

The amount you get depends on the scheme’s accrual rate. This is a fraction of your salary, multiplied by the number of years you were a contributing member.

Typically, these schemes have an accrual rate of 1/60th or 1/80th. In a 1/60th scheme, this means that if your salary was £30,000, and you worked at the firm for 30 years, your annual pension would be £15,000 (30 x 1/60th x £30,000 = £15,000).

How your salary is defined depends on the type of scheme. In a final salary scheme, it is defined as your pay at retirement, or when you leave, if earlier. In a career average scheme, it is the average salary you’ve been paid for a certain number of years.

Index linked pension income

Pension income is normally index linked to ensure that its purchasing power is not eroded by inflation. In public sector schemes, your pension is usually fully index linked. In the private sector, this protection may be capped at a maximum of 2.5% a year. Many DB schemes currently match the retail prices index (RPI), although public sector schemes moved to the consumer prices index (CPI) in 2011. Many private sector schemes are likely to do the same.

If you've stopped paying into a scheme, the salary used to calculate the sum you eventually receive when you reach pensionable age must also be index linked up to a maximum 2.5% a year.

Taking a tax-free lump sum

Final salary and career-average schemes offer the option of taking a tax-free lump sum when you begin drawing your pension. This is restricted to a maximum 25% of the value of the benefits to which you are entitled. The limit is based on receiving a pension for 20 years - so for someone entitled to £15,000 a year, the maximum lump sum might be £75,000 (25% x £15,000 x 20= £75,000).

Taking a lump sum at the outset may reduce the amount of pension you get each year. The amount you give up is determined by the scheme’s ‘commutation factor’. This dictates how much cash you receive for each £1 of pension you surrender. If it is 12, for example, and you take a £12,000 lump sum, your annual income will fall by £1,000.

Additional company pension scheme benefits

As well as providing pension income, most defined benefit company schemes also offer additional benefits to their members. These include:

Death in service payments to a spouse, civil partner or other nominated individual if you die before reaching pensionable age and/or a continuing partner’s pension if you predecease them after reaching pensionable age.
Full pension if you're forced to retire early due to ill health.
Reduced pension if you retire early through choice. It normally cannot be paid before age 55, and it may be considerably reduced by the scheme’s ‘actuarial reduction’ rules. An actuarial reduction is a cut in the yearly pension (to take into account that it will have to be paid out for more years). It is common to surrender 6% for each year below normal retirement age that you retire. The pension will also be lower, because the number of years on which it is based will be fewer than would have been the case if you’d work a full term.

Defined benefit schemes are now less common

Defined benefit pension schemes were widely offered to employees by large firms, from the 1950s to the 1980s. They are advantageous for members in that the scheme (and by extension, the employer) takes all the investment risk and is obliged to meet the ‘pension promise’ made to each member, regardless of how its underlying investments have performed.

They also became more expensive as the actuarial assumptions they were based on were overtaken by increasing longevity. Average life expectancy after 65 is now to age 82.6 for men and 85.2 for women.

For these reasons, most private sector schemes have now been closed to new members, and replaced by defined contribution (DC) schemes.

A large number remain open to existing members who are still employees, however, or those who have left the firm but built up contributions while they were there and retain the right to a ‘preserved pension’ when they reach retirement age.

Many public sector pensions are still defined benefit schemes, underwritten by central government. This has caused them to be called ‘gold-plated’, as they offer a certainty that few private sector schemes can now match.

But, even in the public sector, pension promises are being cut back with a shift from final salary to career average and increases in the normal pension age.

Closed pension schemes

Because they're so expensive to run, final salary schemes have been closed to new members since the 1990s. This means that new employees cannot join them, but are covered by defined contribution, money-purchase schemes instead.

Until recently, closed schemes continued to remain open to existing members, who carried on making contributions each year and accruing additional years’ pensionable service. Some schemes found this too much of a drain, however, and have opted to close to existing members, too.

When this happens, employees at a firm can no longer pay into the final salary scheme, even though they continue to work for the same employer. Their DB pension is ‘preserved’ in the same way as someone who has left the firm and they are typically invited to pay into a DC (money purchase) scheme for the rest of their career.

This leaves them with two separate pension incomes - one from the old DB scheme, based on the number of years' service and salary at the time of closure, and another from the new DC scheme, based on the contributions they have paid into it.

This is not guaranteed, but depends instead on the scheme’s underlying investment performance (net of charges) and annuity rates at the time the member wants the pension to start.

Insolvent pension schemes

Defined benefit schemes are usually jointly funded by contributions from their members and payments by employers. The amount they need is hard to predict, however, as they have to cover possible investment shortfall and the increasing longevity of scheme members.

Whatever happens, they're obliged to pay out retirement incomes based on salary and service record. The open-ended nature of the ‘pension promise’ has led some pension funds with insufficient funds to meet future commitments.

To protect members of insolvent employers where there is a shortfall in the pension scheme, the Financial Assistance Scheme (FAS) and the Pension Protection Fund (PPF) were established by government.

The first covers schemes that were wound up between January 1997 and April 2005, the second schemes that failed after April 2005.

The PPF ensures that pensioners continue to receive the full amount due up to a cap of £34.049.84 at age 65 (less at younger ages, more at older ages) and that others receive 90% of their expected pension (to a current maximum of £29,748.68 a year at age 65). It is funded by a general levy on occupational salary-related schemes.

If an employer goes out of business and the occupational pension fund (whether defined benefit or defined contribution) has lost money as a result of fraud or other dishonesty, the loss may be made good from the Fraud Compensation Fund. This is financed by a levy on all occupational schemes covered by the fund.

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