Defined benefit and final salary pensions

If you’ve spent any time rummaging round Finder’s pension advice, you’ll know that saving for retirement is vital if you want to live well in later life. And if you have the chance to save into a final salary scheme, you’re one of the fortunate few. These so-called “gold-plated” pensions guarantee you an income for life based on a portion of your salary. Plus, they usually pay an income to your dependants even after you die. Here’s what you need to know about defined benefit pensions.

What is a defined benefit pension?

A defined benefit pension is a type of workplace pension scheme that pays out a fixed, regular income when you retire. This income is based on a proportion of your salary while you were working for an organisation. They’re known as defined benefit because the benefit (or pension income) you will receive is set in advance, based on the rules of the scheme. How much income you’ll get depends on your salary and how long you were a member of the scheme.

These days, defined benefit pensions are increasingly rare, especially for new employees. Most workplace pensions are now defined contribution pensions. They’re called this because the amount you contribute towards your pension is the only known factor. Contributions are invested on your behalf. They’ll build up into what’s commonly called a “pension pot”. You can decide how to use this pot when you reach age 55. Its value will depend on how much you contribute and how well your pension investments perform.

What are the different types of defined benefit pensions?

There are 2 main types of defined benefit pension. Both guarantee you an income as a proportion of your salary. However, they work in slightly different ways. In both cases, the income you receive will depend on how long you were a member of the scheme.

1. Final salary pensions are based on how much you are paid when you retire (or when you leave the scheme if this is earlier).
2. Career average pensions are based on an average of your salary during the time you were a member of the scheme.

As with defined contribution pensions, both you and your employer will typically make monthly contributions to the scheme. Those contributions are then invested. However, unlike defined contribution schemes, you don’t bear the risk of receiving less income if the investments perform badly. With both types of defined benefit pension, your employer is responsible for making sure there’s enough money in the scheme to pay your pension income when you retire. That’s regardless of investment performance.

How is final salary pension income calculated?

With a final salary pension, your annual retirement income is calculated by multiplying your salary at the point you left the scheme by how long you’ve been a member of the scheme, then dividing by something called the “accrual rate”. The accrual rate is a fraction of your pensionable pay and is set by the scheme. Typical rates are 1/60 or 1/80.

The bigger the fraction, the more you’ll receive in retirement. So, 1/60 is a better accrual rate than 1/80.

To illustrate this point, here’s how the final salary calculations would work based on someone with the same salary and length of scheme membership, but different accrual rates:

• Sally has been a member of her employer’s final salary scheme for 20 years and is earning a salary of £36,000 when she retires at age 65. Her scheme’s accrual rate is 1/60. Sally’s entitled to an annual pension income of £12,000 (£36,000 x 20 / 60).
• Tom is also approaching retirement at age 65 and, like Sally, earns £36,000 and has been a final salary scheme member for 20 years. But his accrual rate is only 1/80. This means he qualifies for a lower annual pension income of £9,000 (£36,000 x 20 / 80).

Many final salary schemes also offer something called “index-linking”, which means your pension income is guaranteed to rise every year to keep up with rising prices. Some schemes link this to the Retail Prices Index (RPI). Others may cap it at a specific level, such as 2.5%.

How is career average pension income calculated?

The calculations for career average pensions work differently. You effectively accrue a certain amount of pension income each year, based on your annual salary. Your eventual pension income will be made up of all of the amounts that have been banked each year.

As with final salary schemes, many career average pension calculations take account of inflation.

To keep things simple, we’ll base our illustration on someone who’s been a member of the Teachers’ Pension Scheme for 2 years to show how much they’d have accrued in their career average pension by this point. The Teachers’ Pension Scheme uses an accrual rate of 1/57 plus index linking. The level of index linking can vary year-on-year. We’ll assume 2.5% for our scenario.

• In year 1, our teacher (let’s call her Emily), has a salary of £25,000. By the end of the year, she’d have accrued £438.60 towards her ultimate pension income (£25,000/57).
• In year 2, Emily’s salary has gone up to £28,000. By the end of the year, she’d have accrued £491.23 towards her pension income, PLUS an inflation-linked amount of £10.96 (2.5% of their previous year’s balance).
• After 2 years, they’d have accrued career average pension income worth £940.79.

How do I know how much my final salary or career average pension will be worth?

Calculating how much income you’ll be due from a defined benefit pension isn’t necessarily straightforward, especially when you build index linking into the equation. Fortunately, there’s a simple shortcut. Just check your latest pension statement. It’ll give you an indication of how much pension income you might get, based on your current salary. Forecasts typically assume you’ll stay in the scheme until its default retirement age. Age 65, for example.

Who still offers defined benefit pensions?

Defined benefit pensions were once the norm. But, sadly for pension savers – given the advantages of defined benefit pensions – they’re pretty rare these days. They’re mainly offered by government and public sector employers. For example, teachers are eligible for a career average pension known as the Teachers’ Pension Scheme.

You’ll only find a handful of private sector employers that still offer defined benefit pensions. Most have now switched over to defined contribution schemes, either for new employees or for all members.

If you’re lucky and enrolled in your company’s pension scheme before it switched over, you might still have a final salary pension covering part of your career.

Do I pay tax on contributions to a final salary or career average pension?

No, you don’t. As with defined contribution pensions, the money you pay into a defined benefit pension benefits from tax relief. Typically, with defined benefit schemes, this means that your pension contributions are deducted from your pay before income tax is paid.

Do I pay tax on income from a final salary or career average pension?

Yes. Income from any kind of pension is subject to income tax. This includes private pensions, workplace pensions and the state pension. However, you don’t pay National Insurance on pension income.

In most cases, the income you receive will be paid with the tax already deducted. Your pension income tax rate will depend on your combined income from all of your pensions and any other sources, such as a part-time job.

There is one exception to the rule on paying income tax on pension income. That’s if you take your tax-free pension lump sum. For defined contribution pensions, you can take 25% of your pension pot as a tax-free lump sum. What this equates to for defined benefit pensions is a bit complicated to work out, so you’ll need to check the rules for your specific scheme.

When can I start to take income from a final salary or career average pension?

By default, many defined benefit pension schemes set your retirement age at either 65 or your state pension age. State pension age is currently 66, but is due to rise to 67 by 2028, and then to 68 at a later date.

Some schemes allow you to change the age at which you start receiving income from a defined benefit pension. If this is possible, it is likely to affect the level of income you receive. Take it early – 55 is the earliest possible age – and the level of regular income will probably go down. Delay receiving it, and you might get a higher income.

Can I take money out of my final salary or career average pension before age 55?

Usually not. Even if your scheme allows you to change the age at which you start receiving income, in usual circumstances you won’t be able to move the start date to before you turn 55. There may be an exception to this rule if you become seriously ill or disabled and are unable to work as a result. This is known as “ill-health retirement”.

Can I take a lump sum from a final salary or career average pension?

In many cases, you can take a tax-free lump sum from a final salary or career average pension, just as you can from a defined contribution pension.

In some cases, this will be a benefit offered in addition to the regular income you’ll receive, so you should know what to expect from the outset.

Other schemes will let you trade off some of your regular income for an up-front tax-free lump sum. They’ll calculate how much you’re entitled to using something called a “commutation factor”. This is the amount of tax-free lump sum that will be paid per £1 of pension income given up. There’s likely to be a maximum cap on this. The higher the commutation factor, the better the deal you’ll usually get.

Ask whoever is in charge of the pension how any tax-free lump sum is calculated, and what impact – if any – it will have on your annual income.

Can I transfer my final salary or career average pension to a defined contribution scheme?

In most cases, yes, you can. But the more important question is whether you should.

Transferring a defined benefit pension to a defined contribution scheme involves converting the value of your pension into a cash equivalent. This is then put into a defined contribution pot. You’ll almost certainly lose valuable benefits by doing so. These include a guaranteed income for life and, in many cases, an ongoing pension for dependants after you die.

Some companies will offer incentives for their employees to switch from a defined benefit to a defined contribution scheme. But, even with these benefits, you could be left worse off in the long run. There may be rare cases where making the switch is worth it. For example, if you have a shorter than average life expectancy and no dependants. Even then, your employer would need to place a high enough transfer value on your scheme to make it worth it.

It’s not a straightforward decision to make. Ideally, it’s not one that you should make alone. Getting regulated financial advice before transferring away from a defined benefit scheme is always a good idea. In fact, it’s required if the value of your scheme is more than £30,000. If this is the case, you won’t be allowed to transfer unless you’ve shown you’ve received advice.

And, with some schemes, you can’t transfer from a defined benefit to a defined contribution scheme at all. This applies to what’s known as “unfunded” public sector pensions, including the Teachers’ Pension Scheme and NHS Pension Scheme. You can transfer from these schemes into another defined benefit scheme, but not into a defined contribution scheme.

Is my defined benefit pensions safe if my company goes bust?

Let’s say the employer that provides your defined benefit pension becomes insolvent and the scheme doesn’t have enough money to pay some or any of your defined contribution pension. There’s no need to panic. You’re protected by something called the Pension Protection Fund (PPF). It was set up by the government to protect all defined benefit schemes. How much you might get depends on whether you were over the scheme’s normal pension age when your employer went bust.

• If you were over the normal pension age, you’re entitled to a full pension from the PPF.
• If you were under the normal pension age, you’re entitled to receive 90% of the amount you’d built up when your employer became insolvent.

This protection means that the risk to your pension if your company goes bust is pretty small.

Bottom line

If you’ve been a member of a final salary or career average pension for at least a few years, it’s likely to give a decent boost to your retirement income. And defined benefit pensions are pretty rare these days, so if you have one, think carefully before giving up the benefits by transferring to a defined contribution scheme. If you’re tempted by the incentives your employer offers to do just that, get regulated financial advice to help you make the decision that’s best for you.

Frequently asked questions

• How common are final salary pensions?

  Not very. Once upon a time, they were the most common type of workplace pension. These days, they’re hard to find outside of the public sector. According to the Pension Protection Fund, hundreds close every year.

• Why are final salary pension schemes closing?

  The harsh reality is that they’re closing because they’re more expensive for employers to run. With defined benefit pensions, you’re guaranteed a proportion of your salary as income when you retire, no matter how long you live. And your employer bears the full responsibility for delivering this income. Defined contributions are cheaper and more predictable for employers; their liability is limited to the amount they contribute. The risk falls on you if your pension investments don’t perform as well as hoped.

• How is a final salary transfer value calculated?

  If you’re considering transferring a final salary pension into a defined contribution pension, your scheme administrator will need to convert its value into a “cash equivalent transfer value”. To do this, it will take into account factors such as your age, the scheme retirement age, the cost of living, average life expectancy and the scheme costs and returns. The cash equivalent transfer value is meant to represent the amount of money a defined contribution pension pot would need to hold to cover the guaranteed benefits had you stayed in the defined benefit scheme. A multiple of 20 times the annual income from a defined benefit scheme used to be common. This has been increasing in recent years.

• How is my final salary pension valued for the lifetime allowance?

  The pension lifetime allowance is the total amount you can build up in all your pension savings by the time you take money from the pot, without incurring an extra tax bill. The allowance is pretty high (more than £1 million). With a final salary pension, you usually calculate its total value by multiplying your expected annual pension income by 20. So if, for example, you were due an annual pension income of £20,000, the value of your final salary pension would be £400,000. You need to also add the value of any separate tax-free lump sum.

• What happens to my final salary pension when I die?

  When you die, most final salary and career average schemes continue to pay an income to your spouse, civil partner or other dependants. This is usually lower than the full amount you received. Half of your previous pension income is typical.

Written by

Ceri Stanaway

Writer

Ceri Stanaway is a researcher, writer and editor with more than 15 years’ experience, including a long stint at independent publisher Which?. She’s helped people find the best products and services, and avoid the pitfalls, across topics ranging from broadband to insurance. Outside of work, you can often find her sampling the fares in local cafes. See full bio