How do defined benefit pensions work?
If you’ve seen our comparison of Defined Benefit vs Defined Contribution Pensions you might already know a bit about how defined benefit pensions work. But let’s take a more detailed look, so you are as informed as you can be about DB pensions.
What is a defined benefit pension?
A defined benefit pension works a bit like it sounds. The ‘benefits’ you get are ‘defined’ or fixed, providing a steady level of income throughout retirement.
DB pensions are workplace-based pensions, and how much money you get will be based on your salary and length of service with your employer. You might have heard of defined benefit pensions as ‘final salary’ pensions, but there are other kinds too.
You’ll need to make pension contributions in order to be part of the pension scheme, but the amount you pay into the scheme and the investment returns the scheme achieves will not affect the level of pension you get.
Because of the generosity and security of DB pensions, they are increasingly rare outside of the public sector. Some big companies still use them for long term employees, but they are closed to new members.
How different types of defined benefit pension work
There are two main types of defined benefit pension:
Final salary pension: With a final salary pension, you’ll get paid a percentage of whatever your salary was at the time you left the company or retired from the company.
Career average pension: Like it sounds, a career average pension will pay you a percentage of whatever your average salary was across all your time at the company.
How are defined benefit pensions managed?
Normally, the defined benefit pension scheme of your company will be administered by a board of trustees. They are responsible for making sure the scheme is properly invested and managed. It’s also their job to make sure the pension fund grows enough to cover all the pensions of your employer.
What if my defined benefit pension scheme doesn’t grow fast enough?
Remember when we said a defined benefit pension will give you fixed income regardless of pension scheme performance? How does that work if the board of trustees makes a bad investment decision? Well, if there is a shortfall in the pension scheme, the company is expected to make up the difference. This makes the integrity of the company arguably more important than the underlying investments themselves.
What happens to my defined benefit pension if an employer goes bust?
How do defined benefit pensions work if the organisation behind them fails? In the UK, if a company goes out of business and their pension scheme is left underfunded, there is a Pension Protection Fund (PPF) that can step in. The PPF guarantees you’ll receive at least 90% of your promised pension, and employees who are already state retirement age will receive 100%.
How to calculate your defined benefit pension income
How much you will receive from your defined benefit pension comes down to something called an ‘accrual rate’. In simple terms, each year that you’re a member of the company pension scheme you ‘accrue’ a fraction of your ‘final’ or ‘career-average’ salary. This might be 1/60 or 1/80 per year of employment.
Example: DB pension calculations
Let’s say you spent the last 20 years working at a company that offered a final salary DB pension. When you left the company, you had a final salary of £75,000, and the company uses an accrual rate of 1/60 for its pension scheme. This means your annual payout from this pension scheme would be:
£75,000 x 20 x (1/60) = £25,000 per annum
If you had the same career at a company that operated with an accrual rate of 1/80, you would get £6,250 less per year in retirement:
£75,000 x 20 x (1/80) = £18,750 per annum
It’s important to know the details of your pension scheme. Your company will be able to provide you with this information even if you have left them.
Will my DB pension keep up with inflation?
Most DB pension schemes are inflation-linked. This means your income will rise each year to keep up with inflation. However, different companies use different measures for calculating inflation and decide what your pension increase will be. This will be provided in an annual pension statement, so you know what to expect from the year ahead.
When can I start withdrawing money from my DB pension?
Your employer will have strict rules about when you can start to withdraw your DB pension. Most schemes can be accessed from the age of 65, or state pension age, although some employers will allow access earlier. This is particularly common if you’re in poor health.
On the other hand, if you feel you’re not ready to retire, it is common for scheme to let people delay taking pension drawdowns, and to get a higher income level per year later.
You’ll find more information on your pension statements. Or you can ask your pension provider anything you want to know (they’re there to serve you after all).
How is my DB pension taxed?
Whenever you begin to access your DB pension, the income you receive will be taxed at your marginal rate – just like you paid income tax on your salary when you were working. Depending on the DB scheme you have, you might be able to take a tax-free lump sum as a one-off. Not all schemes grant this.
What happens to my DB pension when I die?
When you die, the way DB pensions work means you don’t have a personal pension pot that you can divide up between loved ones as you choose. However, many defined benefit schemes will continue to provide a portion of your pension drawdowns to your spouse. How much, if anything, varies by scheme and employer.
Can I transfer my defined benefit pension?
There are options to transfer your Defined Benefit pension into a Defined Contribution pension. This can allow you to take advantage of certain legislative freedoms or to access your pension earlier if you want to retire a bit younger than your DB scheme allows. However, this is not something to be done lightly.
Your employer might even offer you incentives to switch to a DC pension scheme, such as an enhanced transfer value. Boosting your pot if you switch. However, DB pensions have some unique benefits and security, and it’s crucial to weigh up what you could be losing if you switch to a DC pension. You should absolutely seek expert financial advice before transferring any pensions.
Can Lomond Wealth advise about my DB pension?
Absolutely. However, it is relatively rare that a DB pension would be better off if transferred to a DC pension. For this reason, at Lomond Wealth, we no longer offer defined benefit to defined contribution pension transfer services.
If you have any questions about how defined benefit pensions work, or DB vs DC pensions, please get in touch. You can also check out our breakdown of DB vs DC Pensions, if you haven’t already.
Lomond Wealth is ranked in the Financial Times’ Top 100 UK Advisors, and we are proud to provide straightforward financial advice you can trust in all areas of pension planning and beyond. Including DB and DC pension.
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