Defined benefit pensions, also known as final salary pensions, are often regarded as the gold-standard for retirement savings. They’re not 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. Final salary pensions in their purest form are also gradually being phased out for most new workers in the public sector, including teachers, the police, civil servants and those that work for the NHS. While some older public sector workers might remain in their existing final salary scheme, new employees tend to be enrolled into another form of defined benefit pension, where your payout in retirement is based on your average career earnings while in the scheme, rather than on your final salary.
What is a defined benefit/final salary pension?
A defined benefit pension – also known as a final salary pension – is a workplace pension that guarantees to pay you an 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, the scheme’s accrual rate, and, in the case of final salary pensions, your salary when you retire, or, with a career average scheme, your average salary while you were a member of the scheme.
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 have a normal pension age (NPA) at which you’re allowed to retire and start receiving your pension income.
Defined benefit pensions can also be 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 final salary pension scheme (rather than career average scheme) that has an accrual rate of 1/60th. So that’s 20/60 then multiplied by 50,000, which gives you an annual 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.
» MORE: Understanding pension statements
Do you get a lump sum with a final salary pension?
Some defined benefits schemes might guarantee you’ll receive a tax-free lump sum when you retire and start to take your pension income.
Alternatively, you might have the option to take a final salary pension lump sum in return for accepting a lower pension income. 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.
» MORE: Rules around pension withdrawals
What happens if my final salary pension goes bust?
If the employer behind your pension scheme goes bust and there isn’t enough money in the scheme to provide a retirement income for all members, it’s likely your pension will be protected by the Pension Protection Fund (PPF). The PPF will assess your scheme to see if you qualify for compensation. How much you might get usually depends on how old you were when your employer became insolvent:
- Members who were over their normal pension age or already receiving their pension due to ill health will continue to get their full pension.
- Members who are under their normal pension age will generally get 90% of their built up pension benefits.
Should I transfer my final salary pension?
For most people, transferring away from a final salary pension is unlikely to be the right option. Seeking independent financial advice is usually a must if you’re thinking of switching from a defined benefit scheme.
Although final salary and career average pensions will pay a guaranteed retirement income for life, defined contribution schemes typically offer more flexibility when it comes to accessing your cash in retirement. This might include more options for passing some of your pension on as inheritance or being able to cash in your pension.
It can be possible to transfer a final salary pension into a defined contribution pension scheme if you want this greater control. Some employers might offer you an incentive to switch too.
However, there are usually significant downsides to moving from a final salary pension to a defined contribution pension. These include:
- Losing a guaranteed income for life.
- You’re taking on more risk, as stock market movements can affect the value of a defined contribution pension.
- You may lose other valuable benefits that come with your defined benefit 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 to a defined contribution scheme. This is because it is ‘unfunded’ which means it is paid for out of general taxation and not linked to a specific pension fund.
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Dive even deeper
A defined contribution pension can be a private pension or a workplace pension and is a way to save for retirement that can combine your contributions, employer contributions, investment returns and tax relief. Once you retire, you can turn that lump sum into an income.