A defined benefit scheme (sometimes called a final salary or career-average pension) is a pension that promises to pay an income for life. Because the level of pension is pre-agreed, this type of pension is called defined benefit. This pension becomes payable once the member has reached the normal retirement age of the scheme. The normal retirement age is often 60 or 65. With the Trustees’ consent it is often possible to take benefits before the normal retirement age, but with a reduction to the income payable. The income payable in retirement is based on three factors.
Historically, the level of pension would be based on the employee’s final salary. However, as schemes have started to reduce their liabilities, many schemes have changed their definition of pensionable earnings from final salary to career average, or average over the last five years of employment. This encouraged workers to take on more senior and higher paid roles towards the end of their employment.
The pension is usually index-linked, so will increase in line with inflation each year. This can be from the point of terminating employment, the scheme closing to further benefit accrual, or from retirement. The inflation protection is often capped at 2.5% per annum.
On the member’s normal retirement date, a pension will become payable. Some schemes have a separate lump sum payable at retirement (often public sector schemes). However, it is more common to have to sacrifice some annual income to provide a one-off lump sum at retirement. For example, an annual pension of £50,000 may reduce to £40,000 if a £200,000 lump sum was taken. Each scheme will have different conversion rates (income to lump sum), known as Commutation Factors.
The scheme will continue to pay the pension to the member for life, usually with inflationary increases annually.
If the member wishes to retire before the normal retirement age of the scheme, a penalty will apply. The penalty is often 4-5% per annum, so by retiring five years early, there could be a reduction in annual pension of 20-25%. Likewise, for late retirement there may be an enhancement to the pension, but this is less common.
Upon death of the member, there will typically be a spouse or civil partner’s pension payable. This is generally 50% or 2/3rds of the member’s pension. There may be a pension payable to a long-term partner, but this payable at the Trustee’s discretion. There is usually a pension for minor dependants. Each scheme will have its own definition of a dependant, children under the age of 18, or 23 if in full time-education are usually included. A scheme will often have different death benefits for death pre and post retirement.
The day to day management of the assets in the pension scheme is the responsibility of the pension scheme trustee. The Trustee, with the help of an actuary will calculate how much money is needed in the pension fund to pay all the pensions due. The Trustee will ask the employer to make regular contributions into the scheme, and if there is a shortfall, additional contributions, known as deficit repair contributions.
This means the employer bears the risk that the returns on the fund may not be sufficient to meet the pension payments due to in the future. Defined benefit schemes are costly to run, and with life expectancy continuing to increase, many employers have suffered substantial deficits in their pension fund. Profitable companies are making additional contributions into their pension scheme. However, struggling companies are finding it increasing difficult to meet the liabilities of the pension scheme. As a result, many employers have closed their defined benefit pension scheme and instead fund defined contribution schemes for their employees.
If the pension scheme collapses due to being inadequately funded (e.g. the employer goes bust and the pension scheme is in a deficit), the Pension Protection Fund (PPF) will take over the remaining scheme assets and pay compensation to the scheme members. However, there will be a limit on how much the PPF can guarantee. The PPF is funded by levies on the existing schemes and is not government funded.
There is a formula to calculate the level of income in retirement. The scheme accrual rate (usually 1/60th or 1/80th) is a fraction of salary and is multiplied by the number of years’ service. For example, if a member of a 1/60th scheme had 10 years’ service, and a pensionable salary of £150,000, their pension entitlement would be £25,000 per annum ((10/60) * £150,000 = £25,000).