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Defined benefit pension schemes, also referred to as final salary pension schemes, are types of pensions whereby instead of accumulating a pension pot over a period of time, they grant you a guaranteed annual income until you die, based on your average or final salary.
|What does a defined benefit scheme fund mean?
|A guaranteed income in retirement
|Are defined benefit pensions still available?
|Yes, mainly in the public and government sector
|Can I transfer a defined benefit scheme fund?
|Definitely, but certain conditions apply
|How much can I get from my DB pension scheme?
|It depends on several factors
Final salary pension: What is it, and should I transfer it?
Final salary schemes, or defined benefit schemes, are types of pensions that provide you with a guaranteed retirement income for life when you retire. Rather than pension income being based on accumulated contributions throughout your working life, as with defined contribution pension schemes, with defined benefit pension schemes, it is calculated depending on which of the two types of defined benefit pension schemes you are a member of.
The final salary pension scheme variant
This type of scheme provides you with an income based on your final salary at the time of your retirement.
The career average pension scheme variant
Career average schemes are what they sound like. They provide you with a retirement income based on the average of your salary spanning the time you are or were a member of the scheme.
Final salary pension schemes are contributed to mainly by your employer. With some schemes, you might have the option to contribute, or it could be a mandatory requirement. Retirement income, whether it’s based on a final salary calculation or an average, is a set figure that is guaranteed regardless of how the underlying investments might have performed. These schemes are quite rare today.
One of the employers still operating a defined benefit pension is the NHS.
The NHS final salary pension
The NHS 1995 pension final salary scheme update is our starting point. At that time, the NHS pension final salary calculation was one-eightieth of the final pensionable pay for the number of years, and part years you were a member of the scheme. In 2008 the figure of one-eightieth was increased to one-sixtieth.
In 2015, another change was introduced. The pension members of the 1995 to 2008 schemes who fell within a specific time frame were entitled to full protection. But those in another time frame would only be eligible for partial protection. You can read about the time frame details in the NHS pension members’ guide.
The most recent change was in 2022 when all members were moved to the 2015 scheme, but without losing any benefits accrued from 1995/2008. As a result, the dates you could access your NHS pension changed too. For details on this change, please refer to the NHS “Your NHS Pension after 1 April 2022” document.
How is final salary pension income calculated?
The three factors used to calculate final salary pension include:
- The length of employment over which you are entitled to claim. This could be 5, 10, 15, 20, or 25 years, each of which entitles you to a certain percentage of the total contribution.
- Your salary, which usually means your full-time salary for the period in the pension scheme.
- The final salary pension provider’s accrual rate. This is normally 1/60th or 1/80th. It is accrued on an annual basis.
Your annual retirement income under a final salary pension plan is calculated by multiplying your salary from when you left the pension scheme by the length of your final salary scheme and then dividing it by the “accrual rate”.
Example: Emily has been a final salary scheme member for 25 years and earns £45,000. Her pension scheme accrual rate is 1/60. Emily will receive an annual pension income of £18,750 (25 x 45,000 x 1/60).
The advantages of a final salary pension for many
Because of the volatility to which stock markets are prone and the risk of inflation, a guaranteed income, despite what is happening with the underpinning investments, is a huge attraction for many.
Other advantages include the fact that the annual income is index-linked year on year to combat inflation, and on death, the income continues to be paid to your partner, albeit at a reduced rate. You may also have the option of taking a tax-free lump sum before you start receiving income.
What are the drawbacks of a defined benefit pension?
While a final salary pension scheme has the benefit of a guaranteed income no matter what, it also has several disadvantages. One is your lack of control as to the choice in what investments are made. Another is reduced flexibility when it comes to drawdown options.
Some defined benefit schemes only allow you to access your pot at 60, 65, or state pension age. Others will grant you access to a tax-free final salary pension lump sum at 55. However, if you take a tax-free lump sum, regardless of your pension age, any future income will be reduced.
Moneyfarm does not offer defined benefit pension scheme plans. Instead, other retirement savings products, such as private pension (SIPP), stocks and shares ISA, and general investment accounts, are available on the Moneyfarm website.
What is a defined benefit pension transfer?
As defined contribution (DC) pension schemes offer more flexibility than defined benefit pensions, for some people, this poses the question – should you do a final salary pension transfer and move your funds into a DC scheme?
To get the overall picture and weigh the pros and cons of defined benefit pension transfer, it’s advisable to get final salary pension lump sum advice from an independent, professional final salary pension transfer specialist.
Are all defined-benefit pensions transferrable?
Not all defined benefit (DB) schemes are transferrable. Cases in point include Civil Service, NHS, and Teachers DB schemes. None of these is transferrable. If you need to figure out what type of workplace pension you have, talk to your employer or pension provider.
Advantages of a final salary pension scheme transfer
There are some benefits of transferring a final salary pension to a defined contribution pension scheme.
- Varied pension income withdrawal
- Earlier access to retirement income
- No insolvency risk from the employer
- The value of your pension can increase in a bull stock market
- Defined contribution pension offer more tax-free cash withdrawals
- Beneficiaries can inherit your unspent pension free of inheritance tax
Disadvantages of a final salary pension scheme transfer
There are some disadvantages of transferring a final salary pension to a defined contribution pension scheme.
- Fall in pension pot value, and the pension fund may run out
- Pension pot is vulnerable to the stock market: Value may rise and fall
- No guaranteed income for life
- May incur higher lifetime allowance tax charge in the future
- No guaranteed income for beneficiaries
- You may have to pay for risk management of your pension or self-manage your pension
Calculating final salary pension transfer value
When you want to leave your final salary pension scheme, your pension scheme provider will give you a cash equivalent transfer value (CETV). The non-cash value is the amount that you will receive in exchange for exiting your final salary pension scheme.
Calculating the CETV (cash equivalent transfer value) is no easy thing. The complexity of a CETV calculation is due to the fact that each provider forecasts the value based on its own estimated actuarial principles. Each provider uses its own calculator, with CETV values varying anywhere from 20 to 25 times your pensionable income. Indeed, some providers offer considerably more generous CETVs and some less.
The UK government accepts two options for final salary pension CETV calculations. One works on the best evaluation of the estimated cost associated with providing the member benefits. The other is where the CETV is paid over the minimum amount.
Reviewing your options
It’s essential to understand any pension you have, be it a defined benefit or contribution workplace pension, a SIPP (Self-Invested Personal Pension), a self-employed pension, or any other pension options, including your state pension.
Knowing what your pension income is likely to be when you reach your chosen pension age is vital. However, don’t overlook the fact that the answer to the question of whether pension income is taxable is yes, it is, and it will have a significant effect on the amount of income you receive.
People often take little notice of their retirement income until they reach their 50s, but it’s never too late to change your investment strategy. Now that you’ve had the final salary pension explained and you understand the pension’s benefits and limitations, reviewing the status of your 50s retirement savings is advisable.
Another option open to you could be a general investment account. Having a diversified portfolio, including some high-return investments in the UK, is a tempting way of boosting your retirement income. For example, if you do so through an ISA, any income you receive would be tax-free.
Be aware that investing carries risks, and your capital may go down in value, potentially resulting in you receiving less than you originally invested.
What happens to my defined benefit pension when I leave a company?
The pension from your job is still yours to keep, and the money in your DB pension remains invested even if you stop making pension contributions. If you decide to keep it with your old employer, the pension scheme will provide you with a pension upon reaching the scheme’s retirement age. However, if you change employers, you can switch to your new job’s defined benefit pension scheme or join a totally different workplace pension scheme.
Can I withdraw money from my defined benefit pension plan?
Yes, you can. However, the schemes’ regulations will dictate the rules regarding when and how you can access your defined benefit pension scheme. Typically, you can only withdraw money from your defined benefit pension when you reach the retirement age of 65 or the state pension age. However, there are instances where specific pension schemes have rules that allow you to make pension withdrawals from age 55, even defer it. However, the early withdrawal option can lead to a reduction in your pension amount. Always be wary of the DB pension scheme that allows you to withdraw early. It may be a pension scam.
How is a final salary pension calculated?
The formula to calculate final salary pension is shown below.
Final Salary = Total Service x Annual Pension x Accrual rate
Total Service = Number of years in the scheme
Annual Pension = Pensionable Earnings
Scheme Accrual Rate = Fraction of your pensionable pay (1/60th or 1/80th or 1/100th)
*Capital at risk. Tax treatment depends on your individual circumstances and may be subject to change in the future.