Regarded as one of the most attractive kind of pension, instead of building up a pension pot over time, a defined benefit or DB provides you with a guaranteed annual income for life. But with higher costs to companies, learn if you still get one and how much you could get in retirement.
What is a defined benefit pension?
Defined benefit pension schemes are often referred to as final salary pension schemes and is a pension scheme that promises to pay an income based on your final salary when you left the company or retired from that company. These days ‘career average’ pensions are more common, which pay out based on your average salary while in that scheme.
How does it work?
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.
Your employer is responsible for ensuring there’s enough money at the time you retire to pay your pension income.
Payouts are based on how many years an employee has worked and, usually, their final salary at retirement. Once retirement income is taken, it is typically linked to inflation until you die.
They usually continue to pay a pension to your spouse, civil partner or dependants when you die, but it is likely that it will pay out at a reduced rate of about 50%.
What are the different types of final salary pension?
There are two types of defined benefit pension: Final salary schemes, which are based on how much you're paid when you finally retire and career average schemes, which are based on an average of your salary across your career. These days ‘career average’ pensions are more common.
Defined benefit pensions vs defined contribution
With a defined contribution, what you receive on retirement is based on the value of the pot built up from your contributions and those made by your employer over the course of your career. These are invested in shares and other assets and, unlike DB pensions, individual savers bear the investment risks.
This means your investments are subject to stock market performance, meaning that a significant market crash can reduce your retirement savings.
Also, unlike DB pensions, a defined contribution pension is a finite pot of money that can run out.
How much could I get?
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.
Using an example from consumer champion Which?, this is how it 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).
Can I switch to a DB scheme?
Until ten years ago, defined benefit company pensions were commonplace. However, few employers still offer them to new employees given the high costs.
About 79% cent of employees contribute to a company pension, but just 8% of these are DB scheme members. DB pensions are most often provided by the public sector.
Despite being in decline, millions of people still hold DB pensions. According to the Office for National Statistics, 1.3 million people are actively contributing, and 11.8 million have a DB pension they will be able to claim in future. There are around £2trn in DB pension scheme assets in the UK.
But in short, no. You cannot switch to a DB pension scheme.
Is my money safe? I heard something about an LDI crash.
Crisis hit the DB sector in the wake of former chancellor Kwasi Kwarteng's disastrous mini-Budget.
To avoid being exposed to market volatility, the schemes typically hedge their positions through gilt derivatives managed by so-called liability-driven investment (LDI) funds.
If yields go up too far and too fast, the schemes need to provide more cash – or collateral – to the LDI funds because their positions become loss-making – they are paying out more money in the transaction than they are receiving.
When the Kwarteng measures sunk gilt prices, and sent yields soaring, funds were forced to sell to meet calls from their lenders for more collateral. To avert the collapse of some funds the Bank of England stepped in.
Every investment has risk, but there is no issue about pension funds' solvency or about the payment of current pensions as they now have stronger funding positions. Also, the Bank of England is working with the Financial Conduct Authority and the Pensions Regulator to "ensure strengthened standards are put in place".
Is my defined benefit pension taxable?