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What is a defined benefit pension?

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Defined benefit vs defined contributionHow defined benefit pensions workHow to calculate defined benefit pension valueAccessing a defined benefit pensionWhat happens if my employer goes bust?

Defined benefit pensions are a type of employee benefit that provides an income in retirement. In this article, we'll explain what defined benefit means and how these pensions work.

Defined benefit vs defined contribution

When it comes to life after work, there are two main types of pension plan you'll come across: defined benefit and defined contribution.

Defined benefit (also sometimes called a 'DB' or 'Final Salary' pension) is a type of pension offered by some employers. On a defined benefit pension plan, your employer will pay you a percentage of your final salary when you stop working.

This is in contrast to a defined contribution (sometimes shortened to DC) where you (and your employer) pay into your pension over the course of your lifetime. The value of your pension comes from your contributions and the performance of your chosen pension fund.

Today, defined contribution pension schemes are far more common than defined benefit.

How defined benefit pensions work

The value of a defined benefit pension plan is decided by your employer. Usually, the amount you receive depends on:

  1. the number of years you worked for the company
  2. your salary when you retire
  3. your pension scheme's 'accrual rate'

Most defined benefit pension schemes pay either a percentage of your final salary or an average of your salary during your time with your employer.

The final amount you receive from a defined benefit pension scheme is also calculated by the accrual rate. Put simply, this is how quickly your final pension will grow. For example, a 1/65th accrual rate means each year you stay with your employer, your final salary pension grows by 1.5385%.

After 25 years, this accrual rate would mean your pension pays you 38.46% of your final salary in retirement.

"Defined benefit means your employer pays you a percentage of your salary when you retire"

How to calculate defined benefit pension value

You can check the value of your defined benefit pension plan by looking at your latest statement. If you can't find your paperwork, you can request another copy by contacting your employer or pension provider.

To calculate how much you'll receive when you retire, you'll need three pieces of information:

  • how many years you've been in your pension scheme
  • your final salary
  • your pension scheme's accrual rate

When you have this, simply multiply your accrual rate by how many years you've worked for your employer. This will give you the percentage of your current salary you'll receive in retirement.

For example, if you've worked for your employer for 30 years, your current salary is £30,000 and your pension scheme accrual rate is 1/65th (1.5385%), your final salary pension will be £13,846.50 each year.

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Accessing a defined benefit pension

You'll be able to take out most defined benefit pension plans when you reach State pension age - currently 65 but rising to 67 in 2028. You don't actually need to retire before you start taking your defined benefit pension.

Your pension payments may come as a regular income, or an initial tax-free lump sum followed by a regular income. Remember, you may need to pay tax on your pension income, depending on the amount you're paid.

Your employer may also continue to pay this income to your partner or loved ones when you pass away.

What happens if my employer goes bust?

It's up to your employer to fund your final salary or career average pension, although you may be required to make a contribution.

If your employer goes out of business before you access your defined benefit pension, the Pension Protection Fund (PPF) should ensure you still receive some amount of the pension you were promised.

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