A defined benefit pension plan, also known as a final salary pension, is a type of workplace pension in which the amount you receive in retirement depends on the number of years you have worked for your employer and your final salary.
How much you get is determined by the rules of your pension scheme, rather than investments or the amount you’ve paid in.
How does a defined benefit pension work?
If you’re lucky enough to have a defined benefit pension plan, this will usually provide you with a guaranteed income in retirement that will keep pace with rising living costs. Providing this income has proved too expensive for some private sector employers, who now usually offer new employees access to defined contribution schemes instead. Defined benefit workplace pension schemes are still offered to most public sector workers, such as teachers, NHS workers, police officers and firefighters.
How is the value of a defined benefit pension calculated?
The amount you’ll get from your defined benefit pension when you retire will depend on the number of years you’ve worked for your employer and your final salary when you stop work, although some defined benefit schemes are based on an average of your salary during the time you worked there.
Your pension scheme will have an ‘accrual rate’ which will determine your actual retirement income – this is essentially a fraction of your final or average salary, typically 1/80 or 1/60, which is then multiplied by the number of years you’ve belonged to the scheme.
Defined benefit pensions vs defined contribution pensions
The advantage of defined benefit pensions is that you have a guaranteed income in retirement. Defined contribution pensions offer no such guarantee.
Instead, any payments you make, along with those from your employer if it’s a company scheme, are invested in the funds you choose, or a ‘default’ fund if you’re not sure where to invest your pension savings.
The amount you end up with in retirement depends on how much you’ve paid in, and how your investments have performed. As the value of investments can go down as well as up, there’s a chance you could end up with less than you put in.
Both defined contribution and defined benefit pensions enable you to take a 25% lump sum from your retirement savings tax-free, although taking this will reduce the amount of income you receive. Any income you receive from either type of pension once you’ve taken 25% tax-free is taxable.
Should I transfer my defined benefit pension?
Some people with a defined benefit pension plan decide to transfer their retirement savings to defined contribution schemes. What are the advantages of a defined benefit pension transfer?
Defined contribution schemes allow you to take advantage of pension freedom rules introduced in 2015. Under these rules, pension savers with defined contribution plans usually have the option to take as much as they wish out of their pension pots once they reach the age of 55, rising to 57 in 2028. This opens up more pension options at 55.
However, defined benefit pensions don’t offer this flexibility. You receive a set amount each year – which rises in line with inflation – and you can usually only take your pension once you reach your scheme’s ‘normal retirement age’ (typically 60 or 65).
Another reason people consider transferring is that you can’t usually pass on a defined benefit pension to your children or grandchildren. It will often simply stop being paid when you die, although if you die after reaching your scheme’s pension age it must offer benefits to your surviving spouse or child.
However, if you have money in a defined contribution pension, your retirement savings can go to your children or any other beneficiary you’ve nominated tax-free if you die before you reach the age of 75. You can still pass your pension to a nominated beneficiary if you die after the age of 75, but the recipient will have to pay income tax on the income they receive from it.
However, transferring away from a defined benefit pension plan is unlikely to be in most people’s best interests, as you’re essentially giving up a guaranteed stable income that is protected from inflation for a cash lump sum. Some people choose to transfer their defined benefit pension into a SIPP (self-invested personal pension), a personal or stakeholder pension, or a pension scheme with another employer, but not all pensions accept transfers so you’ll need to check.
When transferring, the value of your defined benefit pension, known as the ‘cash equivalent transfer value’ is calculated by your scheme and is based on the amount you’d need to provide you with the future benefits you’re giving up. This sum may not provide you with enough to live on, and there’s a risk you could end up spending your retirement savings too quickly.
Given the possible pitfalls of transferring a final salary pension, you should seek professional pension advice first so you fully understand the potential risks and pension costs. Under Financial Conduct Authority (FCA) rules, you must seek advice if your pension transfer value is worth more than £30,000.
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