Defined benefit pensions
Defined benefit pensions are less common these days, but you may have acquired one with a former employer or be fortunate enough to have one if you work in the public sector or for a large bluechip company. This guide is designed to provide information about defined benefit pensions and what they mean for your retirement.
FAQs
What is a defined benefit pension scheme?
Defined benefit pension schemes, often referred to as 'final salary' pensions, are pension schemes provided by employers that guarantee to pay you an income from the day you reach retirement age, for the rest of your life. Because they offer this guarantee, they are often preferred over defined contribution pension schemes, which may offer greater retirement benefits and flexibility, but do not offer the same peace of mind that you get from having the certainty of receiving a known income in your retirement years.
The amount of income you get and the benefits your scheme offers varies from employer to employer, and on when you started your scheme, how long you were a member, and many other factors. Typically, the more you earn, the more senior position you hold within your organisation, and if you have been at the company for a long time, the better the benefits you will receive from your defined benefit scheme.
With defined benefit schemes, it is the responsibility of your employer to ensure there is enough money in the pot to pay scheme members this guaranteed retirement income. As people are living longer, healthier lives, this places a huge potential future liability on your organization, hence defined benefit pensions are fast becoming a thing of the past. The benefit for you, if you have a defined contribution scheme, is that your company assumes total responsibility for the risk of your retirement pot, not you.
What is the difference between a defined benefit and defined contribution pension?
Defined benefit schemes, often referred to as 'final salary' schemes, provide you with a guaranteed income when you retire, and your employer takes complete responsibility for any investment risk and ongoing charges. As such, the outcome/benefit is known (defined).
Defined contribution schemes, often referred to as 'money-purchase' scheme, are any other type of personal or occupational pension scheme arrangement. You and/or your employer contribute towards your retirement fund but there is no guarantee on what your pension income will be in the future - The amount you receive from your pension depends on the amount of money you have accumulated in your pension pot when you retire. You bear the investment risk and ongoing charges, not your employer, and as such, only the contribution is known (defined).
Nearly all modern workplace and personal pensions, (SIPPs, SASS, Stakeholder pensions, QROPS, etc.), are defined contribution pensions. Your contributions will be invested in a mixture of investments chosen by you. The value of the benefits you will receive on retirement is then determined by the total value of the investments purchased by the contributions. Simply put the more you pay in and the better the investments perform, the more you could get back when you retire.
Is there a benefit to transferring out of your DB scheme?
If you have a public sector pension and that pension is 'unfunded' (e.g. NHS), you are no longer allowed to transfer your pension to another pension scheme, even if you want to. If your scheme is 'funded', which is the case for company pension schemes and certain public sector pensions, that means you can transfer a cash value to a defined contribution pension. However, you may face certain restrictions on what scheme you can transfer your pension to, especially if you are trying to transfer your scheme to an overseas pension.
If your defined benefit pension has a cash equivalent transfer value of £30,000 or more, it is a mandatory requirement for you to take financial advice from a UK regulated financial advisor. You will be asked to sign declarations, stating that you are fully aware of the benefits and the risks of transferring your pension. Opting to transfer a defined benefit pension to a defined contribution pension is unlikely to be in most people’s best interests and it is not a decision to be taken lightly. However, it can be beneficial in certain circumstances.
This is a complex area of financial planning and our suitably qualified, unbiased and regulated financial advisers can provide clarity and help answer some of the following questions:
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Will your defined benefit pension meet your income needs in retirement?
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Can you afford to retire early?
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Should you take the tax-free lump sum or a higher guaranteed income?
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What should you do with the tax-free lump sum?
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How will your family be looked after when I am no longer here?
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Would the flexibilities offered by a defined contribution pension better meet your own unique needs and requirements?
How much will your defined benefit pension pay out?
Although schemes differ from employer to employer, and even from scheme to scheme within the same employer, the income you will get when you retire will normally be based on the following:
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Your salary (pensionable earnings) while working - this could be based on either your final salary or an average of your salary over your career (Career Average Relevant Earnings).
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The number of years you worked with your employer - either as-at retirement or at your date of leaving your company.
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The percentage of your salary counted towards your retirement income (accrual rate) - normally stated as a fraction, i.e., 1/80th.
for example, assuming you retire on a final salary of £40,000 and have worked with your company for 25 years, and the percentage of your salary that counts towards your entitlement is 1/80th, your pension income would be:
£40,000 x (25 x 1/80) = £12,500 per annum
This amount would then rise each year by a predefined amount to take into account the rising cost of living.
Please note that the above is an example. You need to get the specific calculations used for your defined benefit pension scheme from your employer. If you need help obtaining this information, please use our free pension tracing service.
Will you pay tax on my defined benefit pension?
You are normally entitled to take what is known as a pension commencement lump sum (or PCLS) when you start your retirement. PCLS benefits are lump-sum payments which you can receive 100% tax-free. After that, any income you receive will be taxed at your marginal rate, taking into consideration an other income sources that you may have.
With defined contribution pension schemes, the PCLS is a percentage of the value of your pension pot - the maximum PCLS being 25% for any type of UK pension scheme. With defined benefit schemes, the calculations used for determining your PCLS can be complicated. Sometimes, your PCLS can be allocated a separate pot to the one from which you will receive an income. Or it may be your employer gives you the option to convert (or commute) some of your pension income into a lump sum.
Where the PCLS is allocated to a separate pot, the calculation is usually similar to the way your guaranteed income is calculated. Usually, this will be a higher percentage of your salary, perhaps 3/80 instead of 1/80. Base on the retirement income example above, your PCLS would be:
£40,000 x (25 x 3/80) = £37,500 lump sum
This would be deemed to be your pension commencement lump sum (PCLS) and be paid to you tax-free.
If your employer's pension scheme terms dictate that your PCLS is converted from part of your pension income, the PCLS that you will get will be based on what’s known as a 'commutation factor'. For example, if your commutation factor is 12, you'll receive £12 of PCLS for every £1 of guaranteed income you give up, with the maximum being capped at 25% of your pension value.
Quite often, if you choose to convert your pension income to a PCLS, you would stand to give up more than 25% of your annual pension income. Therefore, depending on your personal circumstances, it may not always be in your best interests to opt for any lump sum.
Please note that the above is an example. You need to get the specific calculations used for your defined benefit pension scheme from your employer. If you need help obtaining this information, please use our free pension tracing service.
When can you take your pension?
Your defined benefit scheme will have a specific normal retirement age (NRA) and this age determines when you can access you can access your pension benefits. You may have the option to take your benefits earlier, but you should be aware of any early reduction factors that may apply.
Most defined benefit pensions have a normal retirement age of 65.
It may also be possible to take your pension without retiring although this may not be particularly tax efficient depending on your other sources of income.
Finally, you might be able to defer taking your pension, which may mean you get a higher income when you do take it.
What happens if your company can't pay your pension?
A number of people are rightly concerned about what will happen to their pension if the company promising to pay your pension income fails or cannot afford to meet its obligations.
Importantly, if this does happen, the Pension Protection Fund compensates you up to certain limits.
From 6 April 2019 defined benefit income entitlement of up to a maximum of £40,020 per annum would be provided.
The maximum compensation you receive depends on whether you have reached normal retirement age or not, if you are taking an ill-health pension or if you are in receipt of a widows/widowers/children's/civil partner’s pension.
Any compensation paid will be increased annually in line with inflation - capped at 2.5% - and not with the former scheme rules.
What happens when you die?
With most defined benefit pension schemes, your spouse, civil partner, or dependants will be eligible to receive an income from your pension when you are gone. Typically, the benefit they will be entitled to is 50% of your pension income as of the date of your death.
If you have converted some of your income into a lump sum at outset, the death benefits are often based on the income you were entitled to prior to conversion.
Any dependant’s pension will end on their death and it is not possible for future generations to benefit.
If you die before drawing your benefits, the scheme may also pay a lump sum in addition and/or return the contributions you have made.
What is the next step?
Pensions are complex and you need to ensure that you are armed with the correct information, based on your personal circumstances and objectives, in order to make an informed choice when choosing, or transferring, any pension plan. It is recommended that you take professional financial advice to ensure that you have the correct plan to meet your needs and that you are on track to meet your retirement goals.
Connect with an expert through our network of UK-qualified Independent Financial Advisors. Through our introduction, you will be entitled to a free, no-obligation pension review.