What are the three types of formulas used to determine pension benefits for defined benefit pension funds?

What is a defined benefit pension?

A defined benefit (DB) pension scheme is one where the amount you’re paid is based on how many years you’ve been a member of the employer’s scheme and the salary you’ve earned when you leave or retire.

They pay out a secure income for life which increases each year in line with inflation.

You might have one if you’ve worked for a large employer or in the public sector.

Your employer contributes to the scheme and is responsible for ensuring there’s enough money at the time you retire to pay your pension income.

You can contribute to the scheme too, and, depending on the scheme, this may be a requirement.

They usually continue to pay a pension to your spouse, civil partner or dependants when you die.

How does a defined benefit pension work?

There are two types of defined benefit pension, final salary schemes and career average schemes.

What does final salary pension mean?

These are based on how much you’re paid at the point you leave the scheme or retire if you’re still working for the employer.

What does career average pension mean?

These are based on an average of your salary throughout your career.

Defined benefit pension schemes provide valuable benefits as they offer a guaranteed pension income when you retire. This is based on salary and length of service.

In this way, they provide members with some certainty about their retirement income.

They’re usually backed by a sponsoring employer, but sometimes the benefits have been secured by transferring to an insurance company.

To spread investment risk, schemes typically invest in a range of assets. These can include company shares, property, and long-term government bonds.

Many defined benefit schemes have either been closed to new members, or to all members, in recent years. But you might have one if you’ve previously worked for a large employer or in the public sector. 

How are defined benefit pensions managed?

Typically, defined benefit schemes are run by a Board of Trustees, on behalf of the employer. Trustees are responsible for all aspects of the scheme. This includes paying out benefits to retired members.

Daily management of the scheme is typically done by the scheme administrator, who reports to the Board of Trustees.

The way your pension benefits are calculated depends on whether you’re in a Final Salary Scheme or a Career Average Scheme.

• A pension calculated by multiplying how long you’ve been a member of the scheme by your final salary (this could be an average of a number of your final years), then dividing by a fraction – such as 1/60th or 1/80th – of your pensionable pay. This is known as the accrual rate.
• A pension lump sum might be paid as well as your pension, or you might have to give up some income to take a lump sum – the lump sum is normally paid tax free to you.

• A pension based on the average of your pensionable earnings throughout your membership in the scheme, revalued in line with inflation.
• The value of pension earned in each year is calculated using a fraction – such as 1/60th or 1/80th – of your pensionable pay. This is known as the accrual rate.
• Your final pension is calculated by adding together all the revalued pension earned in each year of membership.

The pension scheme’s rules will define what is meant by your ‘salary’ or ‘earnings’, and how the calculation of ‘final salary’ or ‘final earnings’ is made.

For example, some schemes don’t count extra earnings, such as:

• overtime
• commission
• bonuses
• the value of benefits in kind – these are other benefits that aren’t paid as cash to the member, for example a company car or private medical insurance.

The scheme might also only count a proportion of your wages or salary. The amount of earnings used to calculate retirement benefits is often called ‘pensionable earnings’.

When can you take your defined benefit pension?

You might also be able to delay taking your pension. This might mean you get a higher income when you do take it. Check your scheme for details.

When you start drawing your pension, it will usually increase each year for the rest of your life. Your defined benefit pension scheme rules will tell you by how much.

Also, don’t forget that your pension income will be taxable – but you won’t pay National Insurance on it.

When you die, it might continue to be paid to your spouse, civil partner or dependants. This is usually a fixed proportion – for example, half (50%) – of your pension income at the date of your death. 

Examples of how your defined benefit pension income might be calculated

Final salary pension scheme

• John is about to retire.
• He’s been a member of his employer’s final salary pension scheme for 40 years.
• The scheme’s accrual rate for building up his pension is 1/80th for each year’s membership.
• John’s final pensionable earnings are £30,000 a year.
• This means that John can receive a pension of £15,000 a year (40/80 x £30,000) from the scheme. 

• Katy started the career average scheme on 1 April 2015, with a pensionable salary of £20,000.
• In the first year, she’ll bank £350.88 as a future pension income – £20,000 x 1/57th = £350.88
• To calculate Katy’s second year, we take the amount banked in her first year – £350.88 – as the opening balance.
• We’ll then add an amount to account for inflation of £10.53 – this example uses 3%.
• If Katy’s pensionable salary remains at £20,000, she’ll add another £350.88 to her pension. This gives her a total banked at the end of the second year of £712.29.
• £350.88 (banked in the first year) + £10.53 (3%) + £350.88 (earned in the second year) = £712.29 banked at the end of the second year.

Tax-free cash lump sum and defined benefit schemes

As well as providing you with a pension income when you retire, some final salary and career average schemes also provide a tax-free cash lump sum.

For example, some schemes with an accrual rate for a pension of 1/80th of final pensionable earnings for each year of scheme membership might also provide a tax-free cash sum of 3/80ths of final pensionable or career average revalued earnings for each year of scheme membership.

Other schemes might offer you the option of taking a tax-free cash lump sum when you retire in return for receiving a reduced pension.

Your scheme should set out:

• the maximum amount of tax-free cash lump sum that can be taken, and
• the amount of tax-free cash lump sum that will be paid for each £1 per year of pension that’s given up. This is often called the cash commutation factor.

Examples of how defined benefit pension lump sums might be calculated

• John has been offered the option of taking a maximum tax-free cash lump sum of £45,000 and a reduced pension.
• The cash commutation factor is £12 of tax-free cash for each £1 of pension given up.
• If John decides to take the maximum tax-free cash lump sum of £45,000, his pension is reduced by £3,750 a year (£45,000/£12) to £11,250 a year.

• Katy’s full pension at retirement is £4,174.
• She’s been offered the option of taking a maximum tax-free cash lump sum of £17,888 and a reduced pension.
• The cash commutation factor is £12 of tax-free cash for each £1 of pension given up.
• If Katy decides to take the maximum tax-free cash lump sum of £17,888, her pension is reduced by £1,491 a year (£17,888/£12) to £2,683 a year.

Checking your pension income

Your latest pension statement will give you an idea of how much your pension income might be.

If you haven’t got one, you might be able to get one online or ask your pension administrator to send you one.

Statements usually show your pension, based on:

• your current salary
• how long you’ve been in the scheme
• what your pension might be if you stay in the scheme until normal retirement age (usually 65)

Will your scheme allow you to take part of your pension as a tax-free lump sum? Then make sure you know whether your statement shows the amount you’ll get before or after taking it. 

If you’ve left your defined benefit scheme

If you were a member of an employer’s defined benefit scheme but have now left, your benefits will usually remain in the scheme.

When you left, the scheme administrator should have provided you with a pension statement. This shows the amount of pension benefits that you have built up in the scheme.

These amounts are usually increased each year in line with inflation. 

If you fall seriously ill and are unable to work, you might be able to draw your pension benefits earlier than age 55.

The amount you get might be less than if you carry on working until you retire.

Taking your defined benefit pension as a lump sum

You might be able to take your whole pension as a cash lump sum.

If you do this, up to 25% of it will be tax-free, and you’ll have to pay Income Tax on the rest. 

You can take your lump sum from age 55 – or earlier if you’re seriously ill – if:

• the total value of all your pension savings, excluding the State Pension, is less than £30,000
• your defined benefit pension is worth less than £10,000, regardless of how much your other pension savings are. You can do this three times for personal pensions and possibly more times for some workplace pensions. 

Defined benefit pension transfers

Are you in a private sector defined benefit pension scheme or a funded public sector scheme? Then you can transfer to a defined contribution pension as long as you’re not already taking your pension.

But if you transfer from a defined benefit pension scheme, you’re giving up valuable benefits and might find yourself worse off. This is even the case if your employer offers you incentives to switch.

The value of your final salary scheme or career average pension scheme when you transfer is really important. These schemes give you guaranteed income in retirement, so if you transfer them, the value you’re offered needs to be appropriate.

It’s a good idea to get advice from a regulated financial adviser who specialises in this type of transfer before you decide. Always ask “How much is my defined benefit pension worth?”.

If your guaranteed benefits are worth £30,000 or more, you’ll have to get financial advice if you choose to transfer.

If you’re in an unfunded defined benefit pension scheme (these are mainly public sector schemes), you won’t be able to transfer to a defined contribution pension scheme.

But you might still be able to transfer to another defined benefit pension scheme. 

Protecting your defined benefit pension

You might ask “Is my defined benefit pension safe?”. All defined benefit schemes are protected by the Pension Protection Fund.

This might pay some compensation to scheme members if employers become insolvent and the scheme doesn’t have enough funds to pay their benefits.

But be aware that the compensation might not be the full amount, and the level of protection depends on your age and other factors.

If you’ve lost track of your pension details

If you’ve lost track of your pension details, the Pension Tracing Service can help you to find the contact information. This is a free, government-backed service.

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