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.