What is a defined benefit pension?
Defined benefit pensions, also known as final salary pensions, pay out a secure income for life. Employers contribute to the scheme and are responsible for ensuring that there is enough money at the time of retirement to pay a pension income. The schemes offer many benefits one of which is ‘index-linking’, this means that pension incomes are guaranteed to rise each year, so that it can keep up with rising prices in the future.
Contributions to a defined benefit scheme go into a pot with that of other members. Employees have no control over their funds or where they are invested. However, if disaster strikes the stock market at the time an employee retires, they will be protected as their company must make up any shortfall.
Defined Benefit pension schemes are advantageous for members because the scheme takes all the investment risk and is obliged to meet the ‘pension promise’ of a pre-defined amount of income made to each member, regardless of how underlying investments have performed.
Most defined benefit schemes have a normal retirement age of 65. This is usually when employers stop contributing to pensions and they start to be paid. Some schemes allow employees to take their pension from the age of 55, but this can reduce the level of income they receive. It is also possible for an employee to take their pension without retiring.
Once the pension is in payment, it will increase each year by a set amount for life. In the event of the employees’ death, it may continue to be paid to their spouse, civil partner or dependants. This is usually a fixed percentage (for example 50%) of their pension income at the date of their death. Defined benefit pension schemes are also becoming more expensive as people are living longer, increasing the time they have to pay out for.
For these reasons, most private sector schemes are now closed to new members, and have been replaced by defined contribution schemes. Whilst few workers contribute to defined benefit schemes today, millions of people have entitlements built up within these arrangement as they were previously commonplace.
Defined benefit pension income
Defined benefit pension income is based on:
Pensionable service – The number of years of membership in the scheme
Pensionable earnings – This could be salary at retirement (‘final salary’), salary averaged over a career (‘career average’) or another formula
Accrual rate – The proportion of earnings received as a pension for each year in the scheme (commonly 1/60th or 1/80th)
How to work out your pension income
Pension income is usually calculated like this:
For example, if:
• You were in a DB pension scheme for 20 years
• You retire at 65 on a salary of £30,000 a year
• Your scheme has an accrual rate of 1/60th
This would give you a pension of:
= £10,000 a year (less if you take a Pension Commencement Lump Sum).
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