Defined Benefit Pensions

A defined benefit pension is a type of workplace pension that provides a guaranteed income for life. Read our guide on defined benefit pension schemes to learn more

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Workplace pensions are the cornerstone of retirement planning.

They help to provide financial security when we stop working, and most of us have one, thanks to automatic enrolment.

According to data published by the Office for National Statistics (ONS), around 8 in 10 eligible employees now have a workplace pension.

There are two main types of workplace pension – defined benefit and defined contribution pension schemes.

In this article, we explore defined benefit schemes. We will look at how they work, tax considerations and other essential information you need to know.

What is a defined benefit pension?

A defined benefit (DB) pension is a type of workplace pension that pays you a guaranteed retirement income. They are also known as final salary pension schemes.

The amount you are paid will depend on the scheme. However, it is usually based on the following:

  • The length of time you have been a member of the employer’s pension scheme
  • The salary you earned when you left the employer or retired

DB pension schemes are far more common for public sector employees.

ONS data shows that nearly 82% of those in the public sector have a defined benefit pension. In contrast, DB pensions only make up 7% of workplace pensions in the private sector and 28% across all employees.

How defined benefit pensions work

A DB pension provides certainty in retirement. That is because, with this type of pension, your pension income is a guaranteed pre-determined amount.

There are two types of DB pensions – career average and final salary schemes.

  • Final salary schemes With these schemes, your pension income depends on how much you are paid when you retire.
  • Career average schemes Your pension benefits are based on your average salary throughout your career.

Each type uses an ‘accrual rate’ as a formula to determine the final salary pension income.

The accrual rate is the rate at which benefits build up and is a fraction of your salary, typically 1/60th or 1/80th. Think of these fractions as portions of your salary you’ll get as your annual retirement income.

The accrual rate is then multiplied by the number of years you have been a part of the DB scheme.

Defined contribution vs defined benefit pension plan

Most workplace pensions today are defined contribution pension schemes.

The value of a defined contribution pension pot is primarily determined by how much has been paid into your pension and the investments have performed over time.

But with a defined benefit pension, its value is based on the following:

  • The length of time you have been with the company
  • Your salary – either a career average or a final salary
  • The accrual rate – the rate at which benefits build up

Unlike a defined contribution pension plan, your employer is responsible for the investment choices.

All DB schemes are covered by the Pension Protection Fund (PPF). While some compensation is offered, it may not cover the full amount of your pension.

defined benefit pension

Can you transfer a defined benefit pension?

A DB pension provides valuable guaranteed benefits, mainly a guaranteed annual pension income. For that reason, transferring a DB is often not advised, as you will be giving up those benefits.

However, DB pensions don’t provide the same level of flexibility that a DC pension offers. This is why some expats may wish to transfer their pension.

While you can usually transfer a DB pension, there are additional steps you must take.

By law, you must seek advice from an FCA-regulated financial adviser if the value of your DB pension you wish to transfer is greater than £30,000. The adviser must have permission for the activity of ‘advising on pension transfers and pension opt-outs’.

Are defined benefit pensions taxable?

A defined benefit pension provides a regular income for life and is treated as taxable income.

This means you pay Income Tax if your total annual income exceeds your Personal Allowance, currently £12,570 for 2023/24 in the UK.

The rate of Income Tax you pay depends on your total income for that tax year. The Income Tax bands for 2023/24 (GBP) are:

  • Basic rate (£12,571 to £50,270) – 20%
  • Higher rate (£50,271 – £125,140) – 40%
  • Additional rate (over £125,140) – 45%

Additional rate taxpayers, those with a taxable income over £125,140, do not get a Personal Allowance.

Some DB pensions also provide a Pension Commencement Lump Sum (PCLS). A PCLS is often known as ‘tax-free cash’ or a ‘tax-free lump sum’.

You can usually take a 25% tax-free cash lump sum from your pension pot. But with a DB pension, the way the lump sum is calculated is often more complex as it is based on the scheme’s ‘commutation factor’.

The commutation factor is used to determine the lump sum percentage. It represents how much of a lump sum you will get for every £1 per year of pension income given up.

For example, if your scheme has a commutation factor of 10, you will get a £10 lump sum for every £1 given up per year.

Pension tax is a complex topic, but understanding it is crucial to ensure you are as tax-efficient as possible. To learn more, read our guide to tax and pensions.

When can you start taking a defined benefit pension?

You can usually access funds at the normal retirement age with a DB pension. This is typically 65 or your UK State Pension age. Some schemes allow you to withdraw 25% of your pension fund as a tax-free lump sum from age 55.

It is best to speak with your pension provider for more details and better understand your scheme’s rules.

Pension planning with Holborn Assets

If you have a defined benefit pension and want to better understand your retirement options and the right course of action for you, we can help.

At Holborn Assets, we provide independent, expert financial advice and wealth management solutions to a global client base.

We take a bespoke approach to retirement planning. Our strategies are tailored to your needs and goals.

Make the most of your retirement. Start planning for tomorrow, today, with Holborn Assets. Book a free, no-obligation meeting today and learn how we can help you maximise your pension savings and reach your retirement goals.

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