A defined benefit or final salary pension is often viewed as the ‘gold standard’ of pensions, as it will provide you with a guaranteed income at retirement.
At the most basic level, there are two main types of pension: defined benefit pensions (or final salary schemes) and defined contribution pensions (also known as money purchase plans). Here, we explain how defined benefit pensions work, what your options are at retirement, and how to make sure your money is working as hard as it possibly can for you. You can find out more about how defined contribution pensions work in our article What is a defined contribution pension?
- What is a defined benefit pension?
- How does a defined benefit workplace pension work?
- How does auto-enrolment affect a defined benefit pension?
- Can I get a private defined benefit pension?
- Where is my defined benefit pension invested?
- How much will my defined benefit pension provide me with when I retire?
- When can I access my defined benefit pension?
- What happens to my defined benefit pension when I die?
- What are the pros and cons of a defined benefit pension?
- Where can I get advice on my defined benefit pension?
What is a defined benefit pension?
A defined benefit pension is a type of company pension that promises to pay out a guaranteed income when you retire. These pensions are often known as ‘final salary’ schemes.
Defined benefit pensions are becoming a rarity, as they are often more expensive to employers and therefore a less sustainable option for them. One area that still offers defined benefit pensions is the public sector, but even here we are seeing newer employees being enrolled in defined contribution schemes instead.
How does a defined benefit workplace pension work?
If you have a defined benefit pension, a special formula is used to calculate your retirement income, which is based on a proportion of your final year’s pay, multiplied by the number of years you’ve belonged to the scheme.
You’ll normally have been given a booklet when you first joined the scheme giving you details of how much you’re likely to get when you retire. If you’ve lost track of this, ask your pension administrator how your plan works and how much you’re likely to receive.
There are a few key things that impact the amount you’ll receive from your final salary pension. These are:
The number of years worked: This means the number of years you worked and were part of the pension scheme. The time with your employer isn’t necessarily the number of years you were contributing to the scheme.
The accrual rate: The rate at which you build up pension benefits while a member of a defined benefit scheme is known as the accrual rate. It’s usually presented as a fraction of your salary (most often 1/60 or 1/80).
Your salary: The way your defined benefit retirement income is worked out will depend on the type of scheme you signed up to. There are two key schemes for defined benefit pensions, which are:
Final salary schemes – these are based on how much your salary is when you retire
Career average schemes – these take an average of your salary across your working life.
As with other pension schemes, your defined benefit pension scheme provider will use the money placed with them to invest in various stocks and shares, bonds, and other assets. However, unlike a defined contribution pension scheme, where you might get back less than you put in when you reach retirement, with a defined benefit scheme, the risk lies with your employer. It is their responsibility to provide you with the income promised at the outset, regardless of how their investments have performed.
Along with longer life expectancies meaning employers are having to pay defined benefit pensions for longer, it is this investment risk that makes these types of pensions so expensive for employers.
How does auto-enrolment affect a defined benefit pension?
Most defined benefit pensions were set up long before auto-enrolment was introduced in 2012 and as a result, it is unlikely that you will be offered a defined benefit pension as your auto-enrolled pension scheme.
If you were part of a defined benefit pension scheme before auto-enrolment was introduced, the minimum requirements that your employer has to meet are different from a defined contribution scheme. Your employer essentially needs to demonstrate that what you will get from your defined benefit scheme is equal to, or better than, what you would get from the defined contribution scheme (where your employer pays 3% of your salary into your pension pot and you pay in 5%).
If you are unsure which type of pension scheme you have been auto-enrolled into, it’s always best to check with your employer.
Can I get a private defined benefit pension?
A defined benefit pension is only available as a workplace pension, so unless your employer has a defined benefit pension scheme, you will not be able to get one.
If you are looking to start building a private pension pot, there are a number of options available to you. You can read more about this in our article Saving into a pension for the first time.
Where is my defined benefit pension invested?
Your defined benefit pension scheme provider will usually invest the money you and your employer place with them in a wide range of different assets, such as stocks and shares, bonds, property and cash. However, unlike a defined contribution pension, all the risk for potential loss on these investments sits with your employer, rather than with you, which makes your pension more stable.
This does however mean that you are less likely to get a say in where your pension is invested, as your employer will choose the investments on your behalf. If you have a defined contribution pension, it’s up to you to decide where the money you’ve paid into it is invested. If you want to know more about how your pension scheme investments work, have a look at our article Where is my pension invested?
How much will my defined benefit pension provide me with when I retire?
One of the major advantages of a defined benefit pension is that you have a clear view of what your pension will be like when you retire. In the broadest terms, the amount you’ll end up with at retirement from a defined benefit pension can be worked out like this:
(Number of years worked x accrual rate) x final salary
Obviously the total you get from this calculation will change throughout your working life, so it’s always best to check your most recent pension statement from your scheme provider, which will give you an idea of what you can expect when you retire. If you can’t find a statement, get in touch with your scheme provider and they will be able to send you one.
When can I access my defined benefit pension?
The majority of defined benefit pensions have a retirement age of 65, which is when your employer stops contributing to your pension and you can start to receive an income from it. With most defined benefit pensions, once you start to receive your payments, the amount you receive each year will increase by a set amount for the rest of your life.
Whether you can take your pension early will depend on the particular scheme you belong to. Some schemes will allow you to take your pension from the age of 55, but it might reduce the amount you are entitled to. You may also be able to defer your pension, if you do not want to start receiving it at 65.
The precise age at which you can access your pension will vary from scheme to scheme, so if you are unsure what you can get and when, it is always best to check with your pension provider.
What happens to my defined benefit pension when I die?
If you die while you’re paying into a defined benefit pension, your scheme will usually pay out a lump sum to your spouse, which is often equivalent to two or three times your salary. You can read more about this in our article What happens to my pension when I die?
Final salary pensions must by law offer benefits to a surviving widow or widower if you die after reaching the scheme’s pension age, although the amount they get could be affected or withdrawn if they decide to remarry later on.
Some schemes will offer payouts for dependent children, but this isn’t the norm. As a result, some people choose to transfer their defined benefit pension to a defined contribution pension to allow them to pass on their retirement savings to their children tax-free if they die before 75.
Bear in mind however, that transferring out of a final salary scheme is rarely likely to be in your best long-term interests, as you are effectively swapping your guaranteed retirement income for a cash lump sum.
Defined benefit pensions also offer some protection from inflation, as your payout rises with the cost of living. The exact provision varies from scheme to scheme, but there is a legal minimum which all schemes have to deliver.
You can find out more about the pros and cons of transferring a final salary pension in our article Should I transfer my final salary pension?
What are the pros and cons of a defined benefit pension?
One of the major benefits of a defined benefit pension is that you know exactly how much you’ll receive as your retirement income before you retire. Your employer makes a commitment to pay you a certain amount and they bear all of the risk on whether their investments will meet this figure.
While this guarantee seems like an optimal situation, there is a risk that if your former employer gets into financial difficulties that your pension could be in danger. The Pension Protection Fund (PPF) was created to help cover defined benefit pension payments that were promised by employers who can no longer pay. However if this happens, you may receive a lower amount than you thought as they have caps on the maximum payments. These are £41,461.07 for current pensioners and £37,315 a year for future pensioners (determined on whether you turned 65 before or after 1 April 2021).
Perhaps the biggest downside of defined benefit pensions is that they don’t offer the same flexibility as defined contribution pensions, which enable you to invest your savings how you want to – and spend your money when you like, once you reach the age of 55.
Where can I get advice on my defined benefit pension?
If you want personal recommendations or advice about your final salary pension, or are considering transferring to a defined contribution pension, you’ll need to seek professional financial advice. You can find a local financial advisor on VouchedFor or Unbiased, or for more information, check out our guides on How to find the right financial advisor for you or How to get advice on your pension.
If you think you might be interested in speaking with a financial advisor, VouchedFor is currently offering Rest Less members a free pension check with a local well-rated financial advisor. There’s no obligation, but once you’ve had your check, the advisor will discuss the potential for an ongoing paid relationship if you think it might be useful to you.
Do you have a defined benefit pension, or are you thinking about transferring to a defined contribution scheme? We’d be interested to hear your views. You can join the money conversation on the Rest Less community or leave a comment below.