Defined benefit pensions, also known as final salary pensions, are a type of retirement plan that offers a guaranteed income for life based on factors such as salary, length of service, and accrual rate. The following guide explores the fundamentals of defined benefit pensions to help you to make choices about your financial future.
It’s worth noting that the landscape of workplace pensions has shifted, with defined contribution pensions becoming more prevalent. While final salary pensions are not as common as they once were, and many schemes have been closing down, they are still offered in the public sector and can be found, although less frequently, in the private sector too.
- What is a Defined Benefit (Final Salary) Pension?
- How does a defined benefit pension scheme work?
- Why might employers choose to offer defined benefit pensions?
- Withdrawing money from your defined benefit pension
- How is a final salary pension calculated?
- What happens if my employer goes bust?
- Can you transfer a defined benefit pension?
- What are the cost implications of defined benefit pensions?
- In Summary
What is a Defined Benefit (Final Salary) Pension?
A defined benefit pension is a retirement plan where your employer promises to give you a specific monthly payment once you retire. This is usually calculated according to how long you’ve worked for the company and your salary history. Your employer takes care of funding and managing the pension plan to make sure there’s enough money to pay you when you retire.
Defined benefit pensions are sometimes referred to as ‘gold plated’ pensions – and for good reason. Unlike a defined contribution scheme, it’s normally based on your salary at retirement age (hence the name ‘final salary’) and can offer an attractive pension throughout retirement.
How does a defined benefit pension scheme work?
While employees can contribute, the employer usually shoulders the majority of the funding. The scheme operates under specific rules and regulations, with trustees overseeing the scheme to ensure fairness and protection for everyone involved.
Why might employers choose to offer defined benefit pensions?
Employers may choose to offer a final salary pension to help them attract talent and encourage loyalty with existing staff members. Knowing they will be financially secure and able to take care of their family in later life provides security and peace of mind for staff – boosting retention and helping to attract talent.
While defined benefit pensions have their upsides for both employees and employers alike, they are costly and some would say unsustainable, especially as life expectancy increases. That’s why many companies have shifted towards defined contribution plans, which require employees to make their own payments.
Withdrawing money from your defined benefit pension
When it comes to withdrawing money from your defined benefit pension, most people receive their payments like a salary. These payments are usually made every month and continue for the rest of your life, and are normally adjusted in line with inflation.
Unlike other pension types, where you have more flexibility in deciding when and how to withdraw funds, you receive a fixed income stream.
However, it’s worth noting that some schemes may offer additional options. For example, you might have the chance to take a tax-free lump sum or make choices about how often you receive payments. There could also be options to provide support to your loved ones after you’re gone.
A defined benefit pension therefore provides you with a regular and dependable income for your retirement years.
How is a final salary pension calculated?
Calculating the benefits of a final salary pension involves various factors, including your salary, length of service, and the scheme’s formula. Typically, the formula multiplies your final salary by an accrual rate and the number of years you have been signed up for. For example, if your final salary is Â£50,000, the accrual rate is 1/60th, and you’ve been a member for 30 years, your annual pension would be Â£25,000 (Â£50,000 / 60 x 30). The calculations can vary, so check the rules and consult with a pension advisor for precise figures.
What happens if my employer goes bust?
One concern is what happens if your employer becomes insolvent. In such cases, the scheme will be taken over by the Pension Protection Fund (PPF), a government-backed fund that aims to provide compensation to members if there’s no money available. The PPF guarantees a certain level of payments, but there may be limitations on the amount of compensation received. It is essential to understand the protections provided by the PPF and assess the potential impact on your benefits in the event of employer insolvency.
Can you transfer a defined benefit pension?
The option to transfer to a different scheme is available in some cases. This allows you to move the value of your pension to a defined contribution scheme or access a lump sum payment.
However, transferring is a major decision and that shouldn’t be taken lightly. It is important to seek professional financial advice to evaluate whether this is suitable for your circumstances. Factors such as your risk tolerance, long-term financial goals, and your personal situation should be taken into account. It would mean giving up the guaranteed income for life and taking on the responsibility of managing your own investments.
If you would like to learn more about the pros and cons of transferring, read our guide: Should I Transfer My Defined Benefit Pension?
Transferring out of a Defined Benefit Scheme is unlikely to be in the best interests of or be suitable for most people.
What are the cost implications of defined benefit pensions?
Defined benefit pensions are more expensive for both employers compared to other retirement plans. Employers bear the responsibility of funding the pension, making regular contributions based on actuarial calculations. While employees don’t contribute, the cost may indirectly impact them through lower wages compared to their counterparts in other organisations.
Defined benefit (final salary) pensions provide a valuable source of income in retirement, offering stability and security. Understanding how they work, including the calculation of benefits and options for withdrawal, is essential as is an awareness of the potential implications of employer insolvency and transferring your defined benefit pension. Seeking professional advice can help you navigate the complexities and help to inform your decision-making which should hopefully set you up for a secure financial future.
To find out more, book an appointment with one of our defined benefit pension advice specialists.
The value of pensions and the income they produce can fall as well as rise. You may get back less than you invested.