What is a Final Salary Pension, and How Do Defined Benefit Pension Schemes Work?
If you have a final salary pension, or defined benefit pension scheme, you will receive retirement income for life. The amount you will receive in retirement is calculated using your salary when you retire or your average salary.
Defined benefit pensions, also known as final salary pensions, are often regarded as the gold-standard for retirement savings. They aren’t very flexible, but the benefits in retirement can be extremely valuable.
The rising cost of running them means they are increasingly rare in the private sector, but they are still standard for many workers in the public sector, such as teachers, the police, civil servants and those that work for the NHS.
What is a defined benefit pension?
A defined benefit pension pays you a set income for life in retirement. The amount you will receive in income is based on the number of years you were a member of the scheme and your salary when you retire in the case of final salary pensions, or your average salary during your career with career average schemes.
You will still likely have to pay into your pension every month, but unlike defined contribution pensions, it is your employer’s responsibility to ensure that there is enough money in your pension when you retire to pay you an income.
» MORE: Workplace pensions explained
How does a defined benefit pension scheme work?
When you join a final salary pension scheme, your pension fund will receive direct contributions from your employer on your behalf. The scheme will decide when it expects you to retire and at that point you will start receiving a pension income.
Most defined benefit pensions are index-linked meaning the amount you receive in retirement will increase each year to keep up with the rising cost of living over time.
Final salary pensions often come with other benefits including:
- Death in service payout – if you die before you hit your pension age your spouse, partner or dependents may receive a payout.
- Ill health pension – if ill health forces you to retire before you reach pension age you may get your full pension early.
- Early pension – You may be able to retire early on a reduced pension if you want to give up work before your retirement age.
How will my final salary pension income be calculated?
The income you receive from a defined benefit pension will be calculated using three factors.
- How long you have been a member of the pension scheme.
- Your final salary (or career average depending on the type of scheme you are in).
- The pension scheme’s accrual rate. This is the proportion of your earnings that you’ll get as a pension for each year in the scheme.
To work out what your final salary pension income may be, take the number of years you have been in the scheme. Multiply that by the accrual rate for your scheme. Then multiply the answer by your pensionable earnings.
For example, let’s say you retire on a salary of £50,000 after 20 years in your pension scheme that has an accrual rate of 1/60th. So that’s 20/60 then multiplied by 50,000, which gives you a pension income of around £16,666.
The simpler way to work out how much income you will get in retirement is to check your pension statement. You should receive one every year and it will show you your projected pension income based on your current salary, how long you’ve been in the scheme and what your pension might be if you stay in the scheme until you hit retirement age.
Can I take a lump sum from a final salary pension?
Once you have turned 55 you can take 25% of your pension as a tax-free lump sum. This is fairly straightforward with a defined contribution pension, but a bit more complicated when it comes to defined benefit, or final salary, pensions.
In order to work out how much you can take you will need your scheme’s commutation factor. This tells you how much of a lump sum you can get for every £1 of income you give up. If your commutation factor is 10 then you’ll get a lump sum of £10 for every £1 of income you give up.
Your pension provider will be able to tell you the value of your potential lump sum.
What happens if my company goes bust?
If your employer goes bust and there isn’t enough money in the pension scheme to provide a retirement income for all members, then the Pension Protection Fund (PPF) steps in. This will ensure that:
- Members who were already receiving their pension will continue to get their full pension up to an annual limit of £41,461.
- Members who have yet to receive their pension will get 90% of their expected pension from age 65 capped at £37,315 a year.
What should I consider when transferring a final salary pension?
Although members of final salary pensions and career average pensions get a guaranteed retirement income, they do not have the same level of control over that income.
If you want you may have the option to transfer a final salary pension into a defined contribution pension scheme.
Defined contribution schemes offer more flexibility when it comes to accessing your cash in retirement, so a lot of people have been tempted to transfer. But there are significant downsides to moving from a final salary pension to a defined contribution pension. These include:
- Losing a guaranteed income for life.
- Stock market movements can affect the value of your pension.
- You may lose other valuable benefits that come with your pension.
For this reason, any member transferring out of a final salary pension with a value of more than £30,000, must get independent financial advice first.
It is also important to note that some public sector schemes, such as the NHS pension, cannot be transferred. This is because it is ‘unfunded’ which means it is paid for out of general taxation and not linked to a specific pension fund.
» MORE: What is a pension transfer?
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Ruth is a freelance journalist with 15 years of experience writing for national newspapers, magazines and websites. Specialising in savings, investments, pensions and property. Read more