UK-based NHS workers, teachers and civil servants usually have final salary pensions. Often called defined benefit (DB) pensions, this type of scheme could offer more generous benefits than other types of pensions. But what exactly are they?
In this final salary pension guide, we'll explain everything you need to know, including how they work, your options at retirement and more.
What is a final salary or defined benefit pension?
Defined benefit pensions are a type of workplace pension. Often referred to as final salary or DB pension, they would appear to be the most attractive type of pension plan for UK workers due to their generous pay-outs.
The main benefit of a final salary pension plan is that it guarantees a set amount you’ll receive once you retire. Final salary or defined benefit pensions are usually offered by public and private sector employers.
How do final salary pensions work?
Final salary pensions connect to your salary and the length of service you’ve given your employer. They’re called ‘defined benefit’ for one reason - you get guaranteed pension income when you reach retirement age.
Like a defined contribution pension, your employer contributes to your defined benefit pension. The difference is your employer must ensure there’s enough money to cover your income payments when you retire and take on more investment risk. This is why many final salary schemes invest in a variety of assets such as government bonds and property.
The amount you could receive at retirement also increases every year because of index linking. This benefit gives you added peace of mind as it’s adjusted with inflation. Your protection might link to the Retail Prices Index or cap at around a set amount, such as 2.5% each year.
Your employer has to contribute enough to your pension to ensure you have enough to live on. What you’re paid depends on the type of defined benefit pension you hold.
Types of final salary or defined benefit pensions
There are two main types of defined benefit pensions: career average and final salary pensions. The type of pension you hold will determine whether you can transfer your pension and how much you could receive at retirement.
How your pension plan is funded also depends on where your pension contributions come from. Public sector final salary pensions are a benefit for the armed forces, NHS workers, teachers, fire service and police. Often referred to as ‘unfunded DB pensions’, they come from taxpayer money.
Private-sector DB pensions are usually funded by your employer. When it was common to have a job for life, these types of pensions were the norm to help encourage loyalty. Nowadays, few employers are willing to offer such a generous benefit to their employees.
Let’s explore each type of defined benefit pension scheme in more detail.
Career average pension schemes
This type of defined benefit pension offers a pension based on your average salary throughout your career. For this reason, they’re most beneficial to workers who don’t tend to get higher annual pay rises.
Final salary pension schemes
This type of pension provides income based on your salary when you retire. Final salary pension schemes can either pay out when you retire (provided you’re still working for the same company) or when you leave the scheme.
Do final salary pensions still exist?
In the past, it wasn’t uncommon for people to have jobs for life as their employers rewarded them for their years of service. And, it’s no surprise that final salary pensions were the most common type of company pension.
Final salary pensions still exist today in public sector jobs such as the civil service, but they’re becoming rarer. As a nation we're living longer, so these pension schemes are more costly than they used to be. And, not all employers are willing to spare the cost or take on the investment risk.
How to calculate a final salary pension
If you’re handy with a calculator, it’s possible to get a rough estimate of how much you could get at retirement with your final salary pension. The key to understanding how much you’ll receive depends on what type of pension you hold and your scheme. Speak to your company’s human resources department if you’re unsure of your pension scheme’s rules.
Doing a little number crunching can help you calculate how much your final salary pension amount. To work out your pension scheme’s value, you’ll need to determine three important figures:
- How many years you’ve been a member of your pension scheme
- Your scheme’s accrual rate (this is usually 1/60th or 1/80th)
- The average of your salary during your whole service
Once you’ve confirmed these details, here’s how you would calculate each value using an example.
Let’s say that:
- Your average salary is £45,000
- Your plan’s accrual rate is 1/60th
- You’ve been a scheme member for 20 years
Now, let’s see how you would work out your pension based on your scheme type.
Calculating a final salary or defined benefit pension:
Working out your final salary pension value involves plugging in your details into a simple formula:
((Pensionable service) / (accrual rate)) x (pensionable earnings)
Adding the above figures should give you the following formula:
(20 / 60 x £45,000)
Your final salary pension should provide you with an annual pension income of £15,000.
Calculating a career average scheme:
These scheme values are more difficult to calculate, but still factor in accrual rate, pensionable earnings and salary. Generally, the amount you receive will be the average of your pensionable earnings. This is calculated by adding up the pension earned for every year that you’re a member of the scheme.
How you calculate your salary and earnings will depend on your scheme’s rules. You’ll also need to note whether you’re entitled to extra earnings such as bonuses, overtime and/or commission.
Use a final salary pension calculator
If you’d rather skip the number crunching, Which’s free final salary pension calculator can help.
Remember, whether you use a final salary pension calculator or do your own calculations, the figure you get will only be an estimate. To get a more accurate figure, request a pension statement from your pension scheme.
Defined benefit vs defined contribution pensions
Both defined benefit and defined contribution pensions provide you with retirement income. But their benefits are very different, and vary depending on which type of pension you hold.
If you’re considering transferring your final salary pension to a defined contribution scheme, you should consider the pros and cons. Transferring your pension could potentially mean losing valuable benefits. You can learn more in our defined benefit vs defined contribution pensions guide.
When can you cash in your defined benefit pension?
You can start taking your pension when you reach ‘normal retirement age’, which is usually age 60 or 65. This is also when your employer stops contributing to your defined benefit pension. Some plans also allow you to take your pension as early as age 55, but may include costly penalties.
Tax-free lump sums and your defined benefit pension
Taking a tax-free lump sum could be an option if you’re part of a career average or final salary pension scheme, but they're complex matters. This may involve taking a sum that’s a percentage of your final pensionable earnings or in return for a reduced pension, based on your scheme's 'commutation factor'.
If your provider says it's an option, you might be able to:
- Take up to 25% of your pension tax-free, and pay Income Tax on anything over this amount
- Potentially take your lump sum earlier if you have a serious illness
Remember, anything you take out today will impact the amount you have to fund your retirement tomorrow. Speak to a financial adviser if you’re thinking about taking a lump sum from your defined benefit, career average or final salary pension. They’ll be able to work out whether it will affect the rest of your pension pot, your scheme’s commutation factor and how much you can take tax-free.
Should you transfer your final salary pension?
If you’re like most people, you’ll have had many employers throughout your career. It’s not uncommon for people to have a mix of final salary and defined contribution pensions. But is it always wise to consolidate pensions into one pot if you can?
You might be permitted to transfer your private final salary or career average pension to a defined contribution pension under the April 2015 pension freedoms. But, you must get regulated financial advice if you’re transferring more than £30,000. And, once transferred, you’ll lose many of your defined benefit pension scheme’s benefits, such as:
- Index-linking: your pension income will rise annually in line with inflation
- Death in service: if you die before you reach pension age your spouse, partner and/or dependents will receive payments
- Guaranteed retirement income for life: you can depend on a pre-agreed amount when you retire
- Pension Protection Fund coverage: almost all DB pensions are covered should their employers go bust
If your scheme lets you transfer your pension to a DC pension, you’ll be able to take advantage of more options as a result of 2015’s pension freedoms. But, it comes at a huge cost - losing guaranteed income for life.
If you’re unsure of whether you’d benefit or lose out from consolidating your final salary pension, speak to a financial adviser.
Taking the next step with your final salary pension
Now that you’ve got a good idea of what a final salary pension is and its benefits, it’s up to you to decide how you’d like to factor it into your retirement plan. It’s a big decision, but support is out there if you don’t know how to tackle it alone.
Getting impartial, professional financial advice can help you understand:
- If your pension(s) can help you afford your preferred retirement lifestyle
- Whether transferring your pension would be a sound option for your circumstances
- The most tax-efficient way to save for retirement
- How to factor your financial goals into your budget
- If transferring a pension could help you better manage your pension pots
We can help you take the first step by matching you with a local pensions expert for free.
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Editor’s note: This article was published in September 2021 and has been updated for accuracy, comprehensiveness and freshness.