Defined benefit pensions: how they work

Despite the fact that more than 16 million of us are due to enjoy the fruits of a defined benefit pension, a great many fewer than that staggering number have fully embraced the finer points of their workings. We may know that they offer the reassurance of a set amount to be paid when we retire, and we know that our employers put in the money. But how are the benefits calculated, and how does the tax work? It’s well worth getting to grips with issues like these… 

How the benefits are worked out

Different employers are allowed to adopt different approaches to their provision of a defined benefit pension. This can add to the complexity. 

Below, however, we highlight the approach most often used in the private sector, and summarise some common variations. If you are a member of a defined benefit scheme it’s best to check your own terms by reading your defined benefit pension paperwork, or by speaking with your scheme administrator.

Three key factors will usually determine your retirement income from a defined benefit pension scheme:

  • The number of years you’ve been in the defined benefit pension scheme
  • Your salary upon leaving the scheme, and 
  • The scheme’s ‘accrual rate’

The number of years and salary are easily understood, although the ‘accrual rate’ may need a bit more explanation. This is the proportion of your leaving salary you’ll get as an annual retirement income, for every year you have been in the scheme. 

Your defined benefit retirement income is usually calculated like this:

  • years in the scheme,
  • MULTIPLIED by your leaving salary,
  • DIVIDED by the scheme’s accrual rate

Here’s an example to show how this works:

Let’s say that…

  • You’re in a DB pension scheme for 10 years, 
  • You retire at 65 on a salary of £24,000 a year, and
  • Your scheme has an accrual rate of 1/60th (i.e. 1/60th of your leaving salary is paid as an annual retirement income, for every year in the scheme)

This would give you an annual retirement income of:

  • 10 (years) MULTIPLIED by £24,000 (salary) DIVIDED by 60 (accrual rate) = £4,000 a year

From the above calculation, you can see that the more years you are in the scheme, the bigger your salary – and the smaller your scheme’s accrual rate, the bigger your defined benefit retirement income is likely to be.

Some ways that defined benefit terms vary

In the above example we assumed an ‘accrual rate’ of 1/60th. This is common in the private sector. In the public sector, however, defined benefit schemes often carry an accrual rate of 1/80th. 

On the surface this appears to be less generous than the private sector’s 1/60th, but public sector schemes often include the additional benefit of a tax-free lump sum. This would be valued at 3/80th of your leaving salary for each year of work. 

Despite the numerical differences, the two variations – in the private and public sector – deliver a similar end-result for the saver. 

How defined benefit schemes can also help your loved ones

Alongside the pension benefit for the member, defined benefit schemes also offer additional benefits such as:

  • Spouse’s, partner’s and dependants’ pensions on death before retirement.   
  • Spouse’s, partner’s and dependants’ pensions on death after retirement.   
  • Lump sum on death before retirement – usually a multiple of salary such as two times or four times. 

This means that defined benefit pensions also help your loved ones cope financially if you die.  

Accessing your benefits

When pensions come into payment – usually at your ‘normal retirement date’ – the whole or part of the pension may increase in line with inflation. The rate of inflation proofing and whether inflation increases are capped, depends on a wide range of factors such as when you were a member of the scheme, and if the pension represents a replacement for the additional state pension. To find out more about this, you can read our State pension article. 

You may be allowed to access your benefits earlier or later than the ‘normal retirement date’. If you are accessing the benefits early then they will usually be reduced to take account of the fact that they will be paid for longer. However, if early retirement is due to poor health, the benefits are usually (but not always) the same as they would have been at your normal retirement date. 

If you retire after your normal retirement age, the benefits you receive will usually be higher than at your normal retirement date.

The benefits offered by defined benefit schemes are diverse and vary from scheme to scheme. Government dictates some of the benefits and features through legislation, while some are voluntary. You should consult the scheme rules or booklet to find out exactly what you are entitled to.   

The tax-free lump sum and how to get it

If there’s one aspect of your defined benefit scheme that you should really get to grips with it is the tax-free lump sum.  How much you take and what part of the pension scheme you take it from can cost you thousands, even tens of thousands of pounds.

What follows in this section doesn’t apply to people, usually in the public sector, whose pension and cash are paid separately. If your defined benefit pension is like this, feel free to skip to the next section. 

However, the vast majority of defined benefit scheme members are in schemes where you have to give up part of your pension to get a tax-free lump sum. This process is called ‘commutation’.

The rate at which you have to give up your pension – the ‘commutation rate’ – to get a tax-free lump sum is what can cost you dearly. 

How commutation works – an example

  • You’re offered a pension of £10,000 a year at retirement. 
  • Alternatively, you can take a tax-free lump sum of £36,000 – but if you choose to do this, your pension will be reduced to £7,000. 

Here’s why:

  • You have exchanged a taxable pension of £3,000 a year for a tax-free lump sum of £36,000. 
  • The ‘commutation rate’ in this calculation is 12 – the rate used in public sector schemes. This means that for every £1 of pension given up, £12 of tax-free lump sum is provided in its place.

But is this a good deal?

  • To buy £1 of annual pension of the sort of paid by defined benefit schemes – with inflation-linking and a spouse/partner’s pension – would cost £44 for a 60-year-old and £36.17 for a 65-year-old.

In our example, you gave up £3,000 of annual pension to get that tax-free lump sum of £36,000. 

To get a better idea of the value of that £3,000 a year – which you’d have for life, remember – think what it might cost to line up that amount by buying an annuity:  

  • To replace £3,000 a year on the open annuity market would cost £132,000 at age 60 or £108,500 at age 65.

In other words, to get £36,000 you have to give up a pension worth well over £100,000. Swapping something that could cost more than £100,000 to buy for just £36,000 must be one of the worst financial deals around.

Granted, the pension is taxable. But even deducting 40% tax, the net (tax-free) value of the pension is still about twice the value of the tax-free lump sum.

What can you do about this?

Some defined benefit scheme trustees allow you to save up for your tax-free lump sum in a separate additional voluntary contribution (AVC) account. As this account is money purchase, every £1 you take is worth £1 of savings, so there is no loss. If you save up enough in this account, you can take all of your lump sum from there without having to give up any of your defined benefit pension. 

If your trustees don’t allow you to take your lump sum from your money-purchase AVC, you could try to persuade them to change the scheme rules. 

Failing that, if you have still to reach retirement, think about saving up for a lump sum in an ISA instead. 

Even once you start drawing your pension, you can build up a lump sum by investing some of your pension in an ISA each month. 

Should you always avoid taking tax-free cash from a defined benefit scheme by commutation?

There are a few circumstances where taking the lump sum might still make good financial sense. 

  • One is when you are in poor health and spending a lump sum makes more sense than a pension, which you are unlikely to receive for too long. A pension for someone in poor health would also be worth less per £1 of pension than in the examples above which are based on someone in good heath. 
  • Another case for taking some cash is to repay debts where you are paying very high rates of interest, like some credit and store cards.
  • Some defined benefit schemes have generous tax-free cash commutation of around £1 pension to £20 tax-free cash, which would represent fair value for a 65-year-old after deducting tax at 40% from the pension. The higher the commutation factor, the more cash you get for every £1 of pension you give up. Or looking at it the other way around, you don’t have to give up as much pension to get your maximum lump sum.

As the example of swapping a £3,000 a year index-linked pension for £36,000 of tax-free lump sum shows, the amount of money that can be lost in this exchange can be huge. If you are in any doubt what is best for you, consider taking financial advice.

 

AR01697  06/2016

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