How Does a Defined Benefit Pension Work?
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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 after a pension is drawn.
The pension will then payout for the employee’s lifetime before reducing to a fixed amount (typically 50%) for the remainder of a surviving spouse. On the death of the spouse, the benefits stop.
What are the Advantages/Disadvantages of Defined Benefit Pensions?
Advantages
The risk of the pension sits with the employer
The fund is the employer’s responsibility with defined-benefit pensions, although usually outsourced to a private provider. As such, the risk of the pension sits with the employer. However, that is not to say there is no risk to the employee (see below).
Ease of planning for retirement
You know the three variables above, i.e. length of service, wage, and accrual rate, so you can relatively easily determine the amount of income you…
