What is a Defined Benefit Pension (DB)?
What is a final salary pension?
A defined benefit pension scheme – sometimes called a final salary pension scheme – is one that promises to pay out an income based on how much you earn when you retire. Unlike defined contribution (DC) pensions, the amount you’ll get at retirement is guaranteed, and it will be paid directly to you – you won't have to use your pension pot to decide your next move. This guide explains how final salary schemes work and how you can work out how much income you could get in retirement.
What are the different types of final salary pension?
If you've saved into a final salary pension scheme, your savings, along with the contributions of your employer and the tax relief you receive from the government, have been invested in the stock market over your working years. But the income you ultimately receive from your pension is a guaranteed, pre-agreed amount. This is why they are called 'defined benefit' pensions. There are two types of defined benefit pension. Final salary schemes, which are based on how much you're paid when you finally retire Career average schemes, which are based on an average of your salary across your career. Both types of pension provide valuable benefits, the biggest of which is something called 'index-linking'. This means that your pension income is guaranteed to rise each year so it can keep up with rising prices in the future. This protection is usually capped at 2.5% a year, although, in some cases, it's linked to the Retail Prices Index measure of inflation.
Other benefits of final salary pensions
Other benefits of final salary pension schemes include: death-in-service payments to spouses, partners or dependants if you die before reaching pensionable age full pension if you have to retire early through ill health reduced pension if you retire early, although this can’t be done before the age of 55.
Private sector v public sector final salary pensions
Defined benefit pensions have historically been provided by both private companies and public sector organisations. Final salary pensions are in decline, but millions of people still hold them. According to the Office for National Statistics, 1.3m people are actively contributing, and 11.8m have a DB pension they will be able to claim in future. If you hold a private sector DB pension, you have the right to request a transfer, as do members of so-called ‘funded’ public sector schemes. In a funded plan, contributions from the employer and employee are invested in a fund towards meeting the benefits. Some public sector schemes, such as those for teachers, NHS workers, the armed forces, the civil service, police, and fire service, aren’t linked to specific pension funds (they’re paid out of general taxation). These are known as ‘unfunded’ DB pensions. These schemes cover somewhere in the region of five million UK residents.
How do I work out my final salary pension income?
If you've saved into a final salary pension scheme during your career, it will provide you an income for your retirement based on three key factors. The number of years you have paid into the scheme; your salary – this might be your final salary when you retire or your average salary across your career sand your pension scheme's 'accrual rate'. This is a formula that's used to calculate your final retirement income. This 'accrual rate' is a fraction of your salary (usually 1/60 or 1/80), and it’s multiplied by the number of years you’ve been in the scheme. Let's look at how this works in practice: Your final salary when you retire is £30,000. You've worked at your company for 40 years. Your company uses an accrual rate of 1/60th. Your annual pension would be £20,000 (40 (years) x 1/60th (accrual) x £30,000 (final salary).
Transfer values for UK final salary pensions may be high, but would you really benefit from giving up a lifetime retirement income for a one-off payment?
If you were offered £235,000 now or an inflation-proofed £10,000 a year for the rest of your life, what would you choose?
This is a similar dilemma faced by many Britons with ‘final salary’ or ‘defined benefit’ employer pensions, as those figures represent today’s average pay-out for members who forfeit their pension benefits for a one-off sum.
Final salary pensions pay a minimum income throughout retirement, usually with yearly cost-of-living increases, until the member dies. Benefits then usually pass on to the spouse at a reduced rate for their lifetime. As such, they are considered highly valuable, even ‘gold-plated’ pensions.
Although the high transfer values offered in exchange for giving up future benefits can be tempting, the UK’s Financial Conduct Authority stresses that most people are better off staying where they are.
While there is no right or wrong approach here, it is essential to take extreme care before making major pension decisions. Start by considering six key questions.
1. What is your pension worth?
The £10,000-a-year example sounds low but could well be enough to provide for a modest retirement, especially when combined with other savings and income. But a one-off sum of £235,000+ could also provide an adequate retirement income if properly managed over time, with potentially more flexibility around withdrawals and currency options.
If you are considering a transfer, be mindful of the UK lifetime pension allowance (LTA). If combined UK pension benefits (excluding the State Pension) breach the 2019/2020 limit of £1.055 million (previously £1.03 million), charges of 55% on lump sums or 25% on income applies on the excess, even for non-UK residents.
The default transfer value for final salary pensions is around 30 times the annual retirement income. However, this does not factor in other pension benefits and will obviously decrease with more generous transfer values.
2. Do you have other resources for retirement?
The UK State Pension currently pays a maximum of around £8,700 a year, so most people need something extra to see them through. Is your pension transfer value high enough to outweigh the benefits of drawing a guaranteed income for life? Or will your other pensions, savings and investments provide for your future? If so, you may be more inclined to forfeit a final salary pension for a one-off reward.
However, if your final salary pension is a large part of your retirement wealth, the certainty of a regular lifetime income will hold more value.
3. How long do you need your pensions to last?
Final salary pensions provide income for as long as you live – with today’s increased life expectancy, that could be 30 years or more from retirement age. Those in good health may benefit more from a guaranteed lifetime income; the opposite may be true for those who do not expect to outlive their resources.
4. How stable is your pension scheme?
Many final salary employers are struggling to meet their obligations. Benefits are usually financed through investments in UK bonds, which have generally under-performed through years of low interest rates. With higher-than-ever life expectancy – meaning benefits must be paid for longer – plus Brexit uncertainty, many are facing significant shortfalls.
The government’s Pension Protection Fund (PPF) found that 3,117 schemes were in deficit at the end of February, with a combined shortfall of £8.6 billion.
While the PPF offers a safety net, it currently only compensates up to £40,020 a year at age 65. If your pension is high value and your scheme is vulnerable, take regulated advice on whether transferring may be in your best interests.
5. What will happen to your pensions when you die?
Most final salary pensions will transfer half the value of the pension to your spouse on death – then go no further. Transferring funds could unlock more estate planning flexibility, such as the option to pass pension funds to other heirs, even across generations, and potentially even reduce inheritance tax liability.
6. What do you want to do with your pension funds?
Clearly, anyone transferring their pension for extravagant purchases, like a sports car or luxury property, may leave little left for retirement expenses. However, any kind of investment comes with risks.
Benefits in a final salary pension are protected – even if the value of funds goes down, the scheme provider is obliged to make the guaranteed payments.
Once transferred, you gain more control over how you invest and access your funds, and can take advantage of tax-efficient opportunities for your country of residence. However, your money is no longer safeguarded and becomes vulnerable to unpredictable markets. Even money in the bank can be eaten away as inflation outpaces returns in this low interest rate climate. While investments can obviously go up as well as down, without proper guidance you risk losing everything to unregulated investments or pension scams.
Whether you should transfer a final salary pension depends on numerous factors and your unique set of circumstances and goals. Taking regulated advice is compulsory if you have benefits worth over £30,000, but it is an important step for anyone considering their pension options. This must be done by having a specialised analysis undertaken this is called the TVAS report.
Remember: once you transfer your pension, you cannot reverse your decision. Take locally-based, UK-regulated advice to fully understand the long-term implications and establish what is best for your financial future in your country of choice.