How Does a Defined Benefit Pension Work?

We discussed in the last blog what the two main types of pension are (DB vs DC). The more traditional pension plan, i.e. Defined Benefit Schemes, has become increasingly rare. If you have a defined benefits pension, you are likely working in the public sector or have a legacy scheme in the private sector. If you have a Defined Benefit pension, I want to go into a little more detail about how Defined Benefit plans work.

A defined benefit plan provides retirement income usually based on three factors:

• Length of service
• Salary of Employee
• The accrual rate of the Pension Scheme

The best way to look at this is with an example of the fictitious pension plan. In this example, if an employee worked for a company for 25 years, finished on a final salary of £50K and the accrual rate was 1/50. The calculation for their retirement benefits would be as follows:

Length of service x Accrual x Final Salary = Retirement income

25 x 1/50 x 50000 = £25000

Typically there is also a tax-free lump sum provided as a multiple of the final salary, e.g. three times, so in this case, that would be £75k

The payout is payable at the scheme’s set retirement date. However, employees can usually opt to commute their pension (at a set rate) by claiming a greater tax-free lump sum in exchange for less income. This approach can be useful if you plan to continue to work…