Defined benefit (or final salary) pensions

What is a final salary pension?

A defined benefit pension scheme - sometimes called a final salary or career average pension scheme - is one that promises to pay out an income based on how much you earn when you retire.

Unlike defined contribution (DC) pensions, the amount you'll get at retirement is guaranteed, and it will be paid directly to you - you won't have to use your pension pot to decide your next move.

This guide explains how final salary schemes work and how you can work out how much income you could get in retirement.

What are the different types of final salary pension?

If you've saved into a final salary pension scheme, 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.

There are two types of defined benefit pension.

• Final salary schemes, which are based on how much you're paid when you finally retire
• Career average schemes, which are based on an average of your salary across your career.

Both types of pension provide valuable benefits, the biggest of which is something called 'index-linking'. This means that your pension income is guaranteed to rise each year so it can keep up with rising prices in the future.

This protection is usually capped at 2.5% or 5% a year, although, in some cases, it's linked to the Retail Prices Index measure of inflation.

Other benefits of final salary pensions

Other benefits of final salary pension schemes include:

• death-in-service payments to spouses, partners or dependents if you die before reaching pensionable age
• full pension if you have to retire early through ill health
• reduced pension if you retire early, although this can't be done before the age of 55.

Private sector v public sector final salary pensions

Defined benefit pensions have historically been provided by both private companies and public sector organisations.

Private final salary pensions are in decline, but millions of people still hold them. According to The Pensions Regulator, 1.2m people are actively contributing, and 9.6m have a DB pension they will be able to claim in future.

If you hold a private sector DB pension, you have the right to request a transfer, as do members of so-called 'funded' public sector schemes. In a funded plan, contributions from the employer and employee are invested in a fund towards meeting the benefits.

Some public sector schemes, such as those for teachers, NHS workers, the armed forces, the civil service, police, and fire service, aren't linked to specific pension funds (they're paid out of general taxation). These are known as 'unfunded' DB pensions.

These schemes cover somewhere in the region of five million UK residents.

How do I work out my final salary pension income?

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.

Let's look at how this 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).

Use our final salary pension calculator

Can I take a lump sum from a final salary pension?

When you retire, the government rewards you for saving into a pension by allowing you to take 25% of your savings completely tax-free.

This is commonly called a lump sum, and taking it will reduce the amount of income you receive from your pension.

With final salary pensions, the way this is calculated is complicated. It's based on the scheme's 'commutation factor', which represents how much of a lump sum you get for every £1 you give up in income.

So if you have a commutation factor of 12, you get £12 of lump sum for every £1 you give up.

You will need to contact your pension scheme to find out how much lump sum you will get from your final salary pension.

Find out more in our guide to taking a lump sum your pension.

Can I cash in or transfer my final salary pension?

As part of the April 2015 pension freedoms, you may be permitted to transfer from a private defined benefit scheme to a defined contribution pension (after taking regulated financial advice).

This has transformed the retirement plans of thousands of people and produced a sharp rise in savers transferring their defined benefit pensions to defined contribution schemes.

However, opting to cash in a DB scheme is not a decision to be taken lightly. It is for good reason that the FCA has taken a keen interest and warned advisers to take a very cautious approach when talking to potential transferees.

A guaranteed income for life via a DB scheme remains the gold standard for pensions. Forgoing this opens up the possibility that you'll have less to live on than expected - and you could even run out of money altogether.

Find out more in our guide to transferring your company pension.

What happens to my pension if my company goes bust?

Some people have cited concerns about their scheme going bust as a reason to consider transferring away from their final salary pensions and all the benefits that it can bring.

However, to protect members of insolvent employers where there is a shortfall in the pension scheme, the Pension Protection Fund (PPF) was established by the government to cover schemes that fail from April 2005 onwards.

Find out more in our guide to the Pension Protection Fund.

Final salary pensions: FAQ