Defined Benefit (Final Salary) Pension Schemes
Defined Benefit (Final Salary) Pension Schemes
Understanding Defined Benefit Pension Schemes
- Defined benefit pension schemes, also known as final salary pensions, are a type of workplace pension.
- The pensioner receives a guaranteed income for life, which is ‘defined’ by set rules within the scheme.
- The payment amount received on retirement depends on the employee’s final salary and length of employment.
How Defined Benefit Pension Scheme Works
- The longer the employee has worked for the company, the higher the pension income will be, hence why it’s often called a final salary pension.
- The pension payment is calculated using a formula that takes into account the number of years an employee has paid into the scheme, their salary, and a pension fraction (e.g., 1/60th or 1/80th).
- As a rule, employers contribute to the scheme alongside the employee, with contributions automatically deducted from their salary before tax.
Role of Defined Benefit Pension in Financial Planning
- Defined benefit pensions offer a secure and predictable income for retirement, helping to reduce financial uncertainty.
- They are considered a lower-risk retirement funding option compared to other types such as defined contribution pensions.
- This type of pension scheme can play a big part in long-term financial planning, providing a steady income stream regardless of external economic factors.
Risks and Limitations of Defined Benefit Pension Schemes
- While the income is guaranteed, it may not keep up with inflation, potentially reducing the purchasing power over time.
- If the employer goes bankrupt, the pension scheme may not be fully funded, though the Pension Protection Fund offers a degree of protection.
- Flexibility can be limited, for example in typically not being able to draw money out before retirement age.
Mitigating Risks and Maximising Defined Benefit Pension Schemes
- Regularly reviewing your pension statement can help keep track of your potential income on retirement.
- It is advantageous to stay informed about any changes your employer makes to the pension scheme.
- If offered a pension transfer, it’s important to seek financial advice before making a decision, as it may not always be the most beneficial option.