A defined benefit, or final salary, pension can be seen as the holy grail of pensions. It’s a type of workplace pension that promises to pay you a guaranteed income from a set age, giving you more security around your income in retirement.
Because your income is secured, you don’t have to worry about the amount you contribute or the performance of your investments to give you an income later in life. Instead, your guaranteed income is determined by the salary you received when working for the company providing the pension and how long you worked there for.
How do defined benefit pension work?
Defined benefit pensions differ in a number of ways from the defined contribution pensions you are probably more familiar with.
- Your employer typically takes a proportion of your gross pay (before tax) as a contribution into your pension
- The income you receive in the future depends on how long you have worked for the company and your salary on leaving/at retirement
- You own a promise from your employer to pay you a certain income for life when you retire, and the scheme rules will tell you how and when you can take this
- Unless you transfer out of your pension (and therefore lose the guarantees it offers) you don’t actually own a pension ‘pot’ and so cannot gift your pot to someone else when you die
- The investment risk is your employer’s. You don’t have to worry how they do it as it is up for them to find the money to pay your promised retirement income
Are there different types of defined benefit schemes?
Yes, there are 3 main types of defined benefit schemes. These are:
Private company final salary pensions
This is a workplace pension set up by your employer and is funded by contributions typically taken from your gross pay.
These are large public-sector state-run pension schemes for people employed by the NHS, civil service, teachers and military. If you are a member, your retirement benefits are paid from the contributions you and all the members have paid, as well as from the government using money raised from income tax.
Local government schemes (LGPS)
This is a statutory public service scheme that is funded by contributions made by both you and your employer. The great news is that you receive tax relief on any contributions you make. This type of pension allows you to take your pension and tax-free cash from the age of 551, however your income amount will reduce if you retire early.
What is the difference between funded and unfunded schemes?
A funded defined benefit pension is one where you and your employer make regular contributions. Your employer then manages the way this money is invested in order to gain the funds to pay your guaranteed income. Because this scheme is funded, there is a pot for you to be able to access. However, if and when you can take your tax-free cash all depends on the scheme you have and accessing this money can reduce the income you receive throughout retirement. A funded defined benefit pension also comes with additional security from the Pension Protection Fund. This means that should your employer fail to be able to pay your promised income, the PPF will step in to make sure you receive this money.
With an unfunded scheme the government is responsible for paying your retirement income, rather than your employer. The government is one of the biggest providers of defined benefit pensions and most of these pensions are paid out using that year’s tax take. This means that there isn’t a standard pension pot for you to be able to access in the same way you might with a funded pension. And you also aren’t able to transfer the pension to a private pension scheme. The good news is, in most cases, the benefits and guarantees this type of pension offers are greater than the restrictions you may face.
Can I take money early from a defined benefit pension?
This all depends on the scheme that you have and whether your pension is funded or unfunded.
With an unfunded pension, the money you are paid as a retirement income comes from that year’s tax take. This means that there isn’t a standard pension pot for you to be able to access.
However, a funded pension is made up from contributions from you and your employer so there is money in a pot for you to be able to access early1. Different schemes have different rules so if and when you can take your tax-free cash all depends on the rules set out by your provider. And taking money early from this type of scheme can reduce the amount of income you will receive throughout retirement. If you are thinking of accessing your defined benefit pension, it’s a good idea to first speak with a financial adviser to make sure that you are not impacting the benefits and guarantees you will receive later in life.
1Taking money from your pension early isn’t right for everyone as it can leave you with less to live on later in life. That’s why it’s a good idea to first speak with a regulated financial adviser.