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What is a defined benefit pension?
A defined benefit pension scheme is one where the amount paid to you is set using a formula based on by how many years you’ve worked for your employer, and the salary you’ve earned rather than the underlying value of the investments held in the scheme. If you work or have worked for a large employer or in the public sector, you may have a defined benefit pension.
Defined benefit pensions pay out a secure income for life which increases each year. They also usually pay a pension to your spouse or registered civil partner and/or your dependants when you die.
The pension income they pay is based on:
The number of years you’ve been a member of the scheme – known as ‘pensionable service’.
Your pensionable earnings – this could be your salary at retirement (known as ‘final salary’), salary averaged over a career (‘career average’), or some other formula.
The proportion of those earnings you receive as a pension for each year of membership – this is called the ‘accrual rate’, and some commonly used rates are 1/60th or 1/80th of your pensionable earnings for each year of pensionable service.
These schemes are run by trustees who look after the interests of the scheme’s members.
In most occupational defined contribution schemes your employer contributes to your personal retirement pot in the scheme, whereas in a defined benefit scheme your employer contributes to the scheme and they are responsible for ensuring there is enough money at the time you retire to pay your promised amount of pension income.
Check your latest pension statement to get an idea of how much your pension income may be. If you haven’t got one, ask your pension administrator to send you one. Statements vary from one scheme to another, but they usually show your pension based on your current salary, how long you’ve been in the scheme and what your pension might be if you stay in the scheme until the scheme’s normal retirement age.
If you’ve left the scheme, you may still receive a statement every year showing how much your pension income will be. In most cases, this pension will increase by a set amount each year up until retirement age. If you do not receive an annual benefits statement, you can contact your pension administrator and they will provide you with one.
The more you take, the lower your income
When you take your pension, depending on the scheme rules you may be entitled to take part of the value of your pension as a tax-free lump sum. With most schemes, your pension income is reduced if you choose to take this tax-free cash. The more you take, the lower your income. But some schemes, particularly public sector pension schemes, pay a tax-free lump sum automatically and in addition to the pension income.
Make sure you understand whether the pension shown on your statement is the amount you’ll get before or after taking a tax-free lump sum. Also, don’t forget that your actual pension income could be subject to income tax, depending on your individual circumstances at the time you take your pension.
The age at which you can start to take an income from your defined benefit pension scheme will be determined by the scheme rules.
If your scheme allows, you may be able to take your pension earlier (currently from the age of 55), but this can reduce the income you receive quite considerably. It is possible to take your pension without retiring. Again, depending on your scheme rules, you may be able to defer taking your pension, and this might mean you get a higher income when you do take it. Check with your scheme for details.
Once your pension starts to be paid, it will increase each year by a set amount – your scheme rules will tell you by how much. It will continue to be paid for life. When you die, a pension may continue to be paid to your spouse, registered civil partner and/or dependants. This is usually a fixed percentage (for example, 50%) of your pension income at the date of your death.
Financial freedom to fulfil your dreams
Retirement should be one of the most enjoyable and fulfilling stages of your life. It should offer exciting new opportunities and the financial freedom to fulfil your dreams – if you have planned well enough in advance.
Accessing pension benefits early may impact on levels of retirement income and your entitlement to certain means-tested benefits and is not suitable for everyone. You should seek advice to understand your options at retirement.
The information in this article is based on our current understanding of taxation legislation and regulations. Any levels and bases of, and reliefs from, taxation are subject to change and tax implications will be based on your individual circumstances.