A defined benefit pension – also known as a final salary pension – is a type of workplace pension that pays you a retirement income based on your salary and the accumulated years you’ve worked for the company, rather than the amount of money you’ve contributed into the pension.
At retirement you may have the option to exchange some of your annual pension for a tax free lump sum and reduced pension. In the event of your death, this type of scheme will normally pay a pension to a spouse or civil partner at a prescribed level, for the remainder of their lifetime.
All investment risk is carried by the scheme, who are also responsible for all decisions about the payment of benefits and protecting the interests of their members.
With a defined contribution pension you build up a pot of money that you can then use to provide an income in retirement, the level of income you receive will depend on the level of contributions made and investment returns.
The level of annual pension you could receive from a defined benefit pension is based on:
- How long you’ve worked for the company.
- The accrual rate: the proportion of your salary you’ll get as an annual retirement income
- Your salary while working: sometimes your final salary, or sometimes an average of your salary over your career
Your company is accountable for making sure there’s enough money in the plan to pay you when you retire. If your employer gets into financial difficulty and can’t adhere to its pension commitments, the Pension Protection Fund (PPF) can satisfy your pension income, but you may receive a lower amount than your employer agreed.
Defined Benefit Pensions are increasingly rare, but you may have one if you’ve worked for a large company or a public sector organisation.
Private sector Defined Benefit Pensions (and some public sector Defined Benefit Pensions) are funded, which means you can get a cash amount for your pension and transfer this fund to another provider.
However, it’s crucial to understand that you’ll lose the some valuable guarantees offered by the pension scheme. Instead, your pension funds will be invested into a defined contribution plan, and the amount it’s worth will be based on how much you’ve contributed and how the investments have performed.
If you have a defined benefit pension that’s worth over £30,000, you have to receive advice from a financial adviser, who is qualified in this area, before a transfer can be permitted.
If you’re in an ‘unfunded’ public sector pension scheme (for example a civil service pension, an NHS pension or a teacher pension), you won’t be able to relocate your pension. That’s because this type of pension uses the employer’s current income to fund pension benefits, rather than setting assets aside.
Generally, your defined benefit pension pays you a retirement income, starting at a certain age (60 or 65, for example). Your pension income grows each year to take into account the increasing cost of living. When you die, a portion of your pension can usually pay out to your partner or dependants.
Under new pension laws, you can take 25% of your pension as a tax-free lump sum when you reach 55 years of age. This is relatively straightforward if you have a defined contribution pension, but when it comes to defined benefit pensions, it can be complex. Your defined benefit pension provider may reduce the retirement income you’re due to get based on how much you’ve taken from your pension as a lump sum.
Please note most defined benefit pension provides will charge you for drawing your pension before the normal retirement age and you financial adviser will be able to provide more information.
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