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A guide to defined benefit pension schemes

Written by Retirement Line

Last Updated: 18th July 2024

How does a defined benefit pension work?

Defined benefit pension (DB) schemes, often hailed as the gold standard of retirement plans, promise a guaranteed pension for your retirement. Although they are less common nowadays, millions of people are in a workplace DB scheme.

If you are a member of a defined benefit scheme, it’s important to understand how it works and the role it might play in your retirement finances. 

To help you understand more about defined benefit schemes, we’ll be covering the following in our guide :

  • What is a defined benefit pension?

  • How does a defined benefit pension work?

  • What is the defined benefit normal pension age (NPA)?

  • What are defined benefit pension transfers?

  • When and how can I take my defined benefit pension money?

  • Defined benefit tax-free cash

  • Do I pay tax on defined benefit pensions?

  • What happens if a defined benefit scheme fails and can’t pay out my income?

What is a defined benefit pension?

These workplace pension schemes are designed to reward your years of service with a guaranteed and regular income in retirement. The scheme is responsible for ensuring there will be sufficient funds available to pay your retirement income. 

Your pension income from a DB scheme is typically based on your years of service and your salary level. This definition differs from a defined contribution (DC) scheme where your eventual income will be mostly influenced by the investment performance of your pension savings.

Your employer contributes to the scheme throughout your employment. Some schemes require you to make contributions to the scheme too, with any money you pay in qualifying for tax relief

Defined benefits schemes typically have some important benefits to members, including: 

  • Guaranteed income. Investment performance will not affect your future income. Your scheme’s trustees will manage your fund investments, but even if they do not perform well, your promised benefits must be paid to you regardless.

  • Inflation protection. Your income from a DB pension will typically increase each year to protect the spending power of your money against the impact of inflation. The increase level depends on the scheme rules. It is usually capped at 2.5% or 5% a year, though some schemes are linked to the Retail Prices Index measure of inflation.

  • Death benefits. DB schemes usually provide an income for your beneficiaries when you pass away. This is usually a fixed proportion – such as half or two-thirds – of your pension income at the time of your passing.

As you can see, being in a defined benefit scheme brings with it valuable benefits compared to other pension schemes. However, the burden of funding them has proven too much for many employers, so these schemes are gradually closing in favour of defined contribution schemes.

How does a defined benefit pension work?

Employers will calculate how a defined benefit scheme will pay out in different ways. Here are two of the most common types of UK defined benefit scheme:

Final salary schemes

The amount of retirement income you will receive is calculated by multiplying your final salary when you left the scheme by the number of years you were in it. You then divide that figure by your scheme’s accrual rate, which is a fraction such as 1/60th or 1/80th.

For example, say your final salary when you retire is £40,000 and you worked at your company for 30 years. If their accrual rate is 1/60th then your annual pension will be £20,000 (30 years x £40,000 x 1/60).

Many people reduce their hours as they approach retirement, so if you have this type of plan you will need to check with your employer or scheme provider to see how your plan may be affected.

Career average schemes

These are also known as a career average revalued earnings (CARE) schemes. This type of scheme uses your average salary from your years of service with your employer to calculate your pension income. 

Every year, you’ll accumulate a pension which is a specific fraction of your pensionable earnings, say 1/60th or 1/80th. This is your scheme’s ‘accrual rate’. 

These amounts will increase through 'indexation', which revalues your pension so that it keeps up with inflation. 

Your annual pension income is calculated at retirement by adding together these amounts from each year of your employment. 

What is the defined benefit normal pension age (NPA)?

UK defined benefit pension schemes have a ‘normal pension age’ (NPA). Though the scheme decides what this will be, it is typically somewhere between 60 and State Pension age. Currently, State Pension age is 66, though this is rising to 67 from 2026. 

Your scheme may have a different NPA – if you’re lucky it may be as low as 55, so you should check with your employer or pension provider.

Of course, the NPA is not the age that you have to retire. You can take your pension from a DB scheme while you are still working.

What are defined benefit pension transfers?

Defined benefit pension transfers involve sacrificing your pension benefits, such as a guaranteed income for life for you and your beneficiary, in return for the cash value. 

This money is transferred to be invested in another pension scheme. You might choose to transfer it to another defined benefit scheme (if the scheme allows) or a defined contribution scheme

If you decide to transfer out of your defined benefit pension, it is important to understand that you cannot reverse your decision. 

You will need to think very carefully before transferring out of your defined benefit scheme. The Financial Conduct Authority (FCA) and the Pensions Regulator (TPR) believe that it will be in most people’s best interests to keep their defined benefit pension. 

Depending on the value of your pension, it may be a legal requirement for you to seek advice before transferring your defined benefit fund. By doing so, you can make an informed decision and fully understand the risks of a transfer.

Be wary of scams

Be vigilant of pension scammers who might try to persuade you to transfer your pension fund, often into a single investment. The government has banned cold calling about pensions. If anyone calls you offering to help you transfer your fund or access your pot before the age of 55, it is very likely a scam. You can check their credentials through the Financial Conduct Authority.

When and how can I take my defined benefit pension money?

A defined benefit pension scheme is typically paid to you as a regular guaranteed income for life from when you reach your scheme’s normal pension age (NPA). If you apply to receive your pension earlier than this, say from 55, you will typically receive less income for life.

You can continue to work after you start receiving your defined benefit pension income.

Some schemes allow you to take a lump sum payment from your defined benefit pension, in one of these ways:

  • Pension Commencement Lump Sum (PCLS). This is known as your tax-free lump sum. Up to 25% of your fund value is usually tax-free. See below for more information.

  • Trivial Commutation Lump Sum (TCLS). This is when you take the whole of your small pension fund as a lump sum, provided certain conditions are met. This lump sum payment is subject to special tax rules.

  • Small-pot lump sum. You can usually cash in a small pension pot of £10,000 or less from the age of 55. Check your scheme provider’s rules on this.

Defined benefit tax-free cash

Depending on your scheme rules, you may be able to take up to 25% of the value of your scheme benefits as a pension commencement lump sum (PCLS). 

The value of your defined benefit pension is typically calculated by multiplying your scheme’s annual pension income by 20. Your maximum PCLS is 25% of this amount.

You should be aware that your annual pension income may reduce if you take a tax-free lump sum. However, this isn’t always the case and rules vary between providers.

You may come across the term ‘commutation factor’ when exploring this option. If you see a commutation factor of 10:1, for example, then it means your annual pension income will reduce by £1 for every £10 of PCLS that you take.

Check your scheme rules to find out:

  • If you can take a tax-free cash lump sum from your fund.

  • How much tax-free cash lump sum can be taken.

  • How the tax-free lump sum is calculated and how your pension income will be affected (if applicable).

Do I pay tax on defined benefit pensions? 

You could pay tax on defined benefit pension income as the income from these schemes is taxable at your marginal rate of Income Tax – but you won’t have to pay any National Insurance on it. (This is the same as with income you take from DC workplace and personal pensions via income options such as annuities and drawdown.)

If you draw smaller lump sums, 25% of each one will be tax-free. You then pay tax at your marginal rate of Income Tax on the remaining 75%. Defined benefit pensions typically offer the option of taking a tax-free lump sum as well as a guaranteed income for life.

What happens if a defined benefit scheme fails and can’t pay out my income?

If you have a defined benefit pension and the scheme fails, the Pension Protection Fund (PPF) may step in. This is typically around 18 months to two years down the line following an assessment period.

Once the assessment period is complete, your scheme will either be transferred to a new provider, an insurer, or the Pension Protection Fund itself.

Regardless of who takes over your pension scheme, they must pay you at least 90% of your current or promised pension income. This is the minimum PPF compensation amount. 

You may find you receive 100%. For instance, if your pension is transferred to the PPF, you’ll receive 100% of your pension if any of the following apply to you:

  • You are already at or over your normal pension age.

  • You retired early due to ill-health.

  • You are in receipt of a ‘survivor’s pension’, where someone died before retirement age and their pension is paid to you.

When your compensation payments begin, you can usually take up to 25% as a tax-free lump sum.

FAQs

Do defined benefit pensions increase with inflation?

Yes, a defined benefit pension income not only guarantees an income for life, but one that rises each year to protect against inflation. 

Some DB schemes will increase the pension payouts annually in line with inflation. Others have an inflation cap for providers to maintain some control over how much they can increase by. Caps vary from scheme to scheme, but are typically between 3-5 per cent.

Is a defined benefit pension the same as final salary?

A final salary scheme is a type of defined benefit pension. Instead of you having to build up a pension pot over your career, a final salary scheme provides you with a guaranteed annual income for life which is based on your salary at retirement. You typically won’t have to make any contributions to your pension during your employment, though some schemes may require you to.

Does MPAA apply to defined benefit schemes? 

The Money Purchase Annual Allowance (MPAA) imposes a limit on the amount of money that you can pay into your pension and still receive tax relief. It is only triggered when you access your defined contribution pension pot for the first time. It does not apply to defined benefit pension schemes.

What is a defined benefit annual allowance?

Please visit ‘Tax on your private pension contributions’ on the gov.uk site for information about how the annual allowance on pension savings works.

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