Find out how defined benefit pension programmes, often known as final salary pension schemes, provide you with an income in retirement, and calculate how much money you might receive.

What exactly is a pension based on one’s final salary?

A defined benefit pension system is a pension scheme that promises to pay out an income based on how much you earn when you retire. This type of pension scheme is also known as a career average pension scheme or a final salary pension scheme.

In contrast to defined contribution (DC) pensions, the amount you’ll earn upon retirement is guaranteed, and it will be given straight to you – you won’t have to utilise your pension pool to select what your next step should be.

This tutorial will walk you through the mechanics of how final salary schemes operate, as well as how to estimate how much money you will receive when you retire.

What are the various options for a pension based on a final salary?

Your funds, as well as the contributions made by your employer and the tax relief you receive from the government, have been invested in the stock market during the course of your working years if you have contributed to a final salary pension scheme during your time in the workforce.

However, the amount of money that is finally paid to you from your pension is a fixed sum that has been agreed upon in advance. This is the reason why these pensions are referred to as “defined benefit” pensions.

There are two distinct categories of defined benefit pension plans.

Schemes that are based on your career average as opposed to your final salary are called career average schemes. Schemes that are based on your final salary as opposed to your career average are called final salary schemes.

Both defined benefit and defined contribution pension plans offer numerous advantages, the most significant of which is referred to as “index-linking.” This ensures that your pension income will continue to grow on an annual basis, allowing it to keep pace with any future increases in the cost of living.

This protection is typically capped at a rate of 2.5 percent per year; but, in certain circumstances, it is linked to the Retail Prices Index, which is a gauge of inflation.

Additional advantages of pensions based on a final salary

Other advantages of pension plans based on a fixed salary are as follows:

death-in-service payments to spouses, partners, or dependents if you pass away before reaching pensionable age full pension if you have to retire early because of ill health reduced pension if you retire early, but you can’t do so before the age of 55. death-in-service payments to spouses, partners, or dependents if you die before reaching pensionable age.
Pensions based on final salaries in the private sector against those in the public sector

Historically, both private enterprises and organisations in the public sector have contributed to the provision of defined benefit pensions for their employees.

Even if the number of people receiving pensions based on final salaries is on the decline, millions of people still have them. The Office for National Statistics estimates that 1.3 million people are currently making contributions, and 11.8 million people have a defined benefit pension that they will be able to claim at some point in the future.

Members of so-called funded public sector schemes have the same right as members of defined benefit (DB) pension plans in the private sector to make a transfer request at any time. A funded plan is one in which both the employer and the employee make payments, which are then invested in a fund in order to pay for the benefits.

Some pension plans in the public sector, including those for teachers, employees of the National Health Service (NHS), members of the armed forces, members of the civil service, police officers, and firefighters, are not linked to specific pension funds; rather, they are paid for out of general taxation. These are referred to as “unfunded” defined benefit pensions.

These programmes are available to anywhere between five and seven million people living in the UK.

How can I determine how much I will receive from my final salary pension?

During the course of your career, if you have contributed money to a final salary pension plan, then when you reach retirement age, that plan will pay you with an income depending on three primary considerations.

The number of years you have contributed to the plan; your pay – which might be your final salary when you retire or your average salary over the course of your career; and the ‘accrual rate’ of your pension plan.

This is the formula that is used to determine the total amount of retirement income you will get. This ‘accrual rate’ is a fraction of your pay (often 1/60 or 1/80), and it is multiplied by the number of years you’ve been in the plan to determine your total benefit.

Let’s have a look at how this operates in the real world:

When you retire, you will receive £30,000 as your final wage.
You’ve spent the last four decades working for the same company.
Your business uses an accrual rate of one sixtyth of a dollar each day.
If you retired after 40 years, your yearly pension would be £20,000 (40 years x 1/60th of £30,000 accrued) (final salary).
Make use of our calculator for ultimate salary and pension.

Can I obtain a lump amount from a final salary pension?

When you retire, the government compensates you for saving into a pension by enabling you to access 25 percent of your funds fully tax-free.

This is generally called a lump payment, and taking it will limit the amount of income you receive from your pension.

With final salary pensions, the method this is calculated is difficult. It’s based on the scheme’s ‘commutation factor’, which measures how much of a lump payment you get for every £1 you give up in income.

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

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

Can I cash in or transfer my final salary pension?

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

This has changed the retirement plans of thousands of people and created a substantial spike in savings changing their defined benefit pensions to defined contribution programs.

However, electing to cash in a DB scheme is not a decision to be done lightly. It is for good reason that the FCA has taken a keen interest and cautioned advisers to adopt a very careful approach when talking to possible transferees.

A guaranteed income for life via a DB scheme remains the gold standard for pensions. Forgoing this puts up the risk that you’ll have less to live on than intended — and you could even run out of money entirely.

What happens to my pension if my company goes bust?

Some people have cited fears about their scheme going bust as a cause to contemplate shifting away from their final salary pensions and all the benefits that it can provide.

However, to safeguard members of insolvent businesses when there is a shortfall in the pension scheme, the Pension Protection Fund (PPF) was formed by the government to cover schemes that collapse from April 2005 forward.

The PPF ensures that:

pensioners continue to get the entire amount owed up to a cap of £41,461.07 at age 65 from 1 April 2021\sothers receive 90 percent of their expected pension – to a current maximum of £37,315 a year at age 65\sit is supported by a general tax on occupational salary-related schemes.