Defined benefit pensions, more commonly known as final salary schemes are a form of retirement plan which are/were solely offered by certain employers. They are most prevalent in the public sector, whilst the majority of private sector employees have either never had the opportunity to participate or have witnessed the closing of their scheme. Private pensions are now invariably defined contribution schemes.

What follows is a look into;

An employer will take responsibility for providing retirees an ongoing, typically increasing, income. The level of benefit is guaranteed based on the terms offered. The two main options available are final salary (most common) and career average revalued earnings (CARE) schemes.
 

Final salary

Your retirement income is determined by how long you have worked for the company and your final salary. Some employers will use an average of your last 3 years salaries to provide a reference for the final salary instead.
 

Career Average Revalued Earnings (CARE)

The CARE system will use your average career earnings accounting for inflation instead of your final salary when calculating your entitlement. This is classed as inferior in comparison to final salary schemes since a person’s salary is expected to rise over their career due to factors including job promotions.
 
Under all schemes, the salary a person’s pension is based upon is their pensionable salary (or pensionable earnings). This may or may not be the same as their actual salary since it can exclude factors including overtime pay, expenses and benefits.
 
An employer has two options regarding the pension scheme’s funding: Pay as you go (unfunded) or funded.

 
Pensions - Defined benefit (final salary) scheme

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  • Retirement income level is guaranteed and not affected by investment performance
  • Income paid on retirement usually rises in line with inflation
  • Contributions are paid as a percentage of current salary. As a salary may experience substantial increases, due to job promotions for example, contributions made in earlier years may be significantly more valuable than the monetary value originally paid in
  • As long as there is sufficient funds within the pension scheme your income is guaranteed
  • In the event of a pension scheme going insolvent up to 90% of the retirement income is guaranteed through the Pension Protection Fund (PPF)
  • Prior to retiring, under the assumption that your salary remains in line with expectations, it is possible to know exactly how much you can expect to retire on
  • Measurements used to determine income on retirement can change. Some examples are: pensionable salary may be lower than your actual salary; the pension age may be increased; and limits can be placed upon future increases so that your pension income doesn’t keep up with inflation
  • Retirement income is only guaranteed as long as there is sufficient funds in the holding pension company. If this is backed by the government then there should be no issue but for company held schemes this is a real risk
  • A fund may close. Companies can do this to limit the risk of running a fund. There are three options: closing the fund only to new entrants; closing the scheme to everyone thus preventing any future accrual of benefits; and complete closure
  • Under the first two methods accrued benefits will still be paid at retirement whilst this may not be the case with a complete closure. Upon the latter the fund is wound up and benefits will only be paid if there is sufficient means. If the scheme can’t honour its commitments it will go bust requiring cover from the Pension Protection Fund (PPF)
  • The PPF only covers 90% of pension income up to £36,401.19 at age 65 (from 1st April 2014). This equates to the highest payout level being £32,761.07 per annum
  • Payments made through the PPF will only rise in line with inflation up to a cap of 2.5% per annum relating to any pensionable service from the 5th April 1997*
  • Payments made through the PPF relating to pensionable service prior to 5th April 1997 will be fixed*
  • The PPF is not government backed thus it is possible for payments to be curtailed further
  • Your defined benefit scheme may limit when you can retire by imposing a normal retirement age, for example 65. Accessing your pension prior to this age may then be penalised. In comparison, a typical defined contribution scheme will allow retirement from 55 penalty free
  • Spousal and dependants benefits on the policyholders death are reduced
  • On death of both the policyholder and spouse nothing could be passed on to their heirs versus the remainder of the pension fund in a defined contribution scheme**
  • Future pension rule changes may prohibit your ability to change to a money purchase scheme

* Information sourced from www.pensionprotectionfund.org.uk/Pages/Compensation.aspx
** During drawdown when the fund remains invested and an income is being withdrawn

This is usually only available to governments or public bodies. Pension benefits are paid out of ongoing income (tax receipts) in a similar manner to state pensions.
On the contrary, funded schemes will see a company contribute into a singular pot and invest accordingly. An actuarial accountant will establish whether or not the overall pension value is deemed sufficient to meet future payment obligations i.e. how much is required to pay existing employees in retirement until their expected death. This may result in a company adding additional pension contributions in cases where there is a deemed shortfall.
Defined benefit pension schemes provide an employee a guarantee in relation to the level of income they can expect to receive on retirement.
 
This is determined by two factors: how long you have worked for the company & your final salary (or career average earnings). An employer will offer a fractional system, to account for the number of years worked, with an overall limit imposed. On top of this you may be offered a pension commencement lump sum (PCLS).
A company may offer an 80th’s scheme. This means that for every year worked you will accumulate an annual income of 1/80 of your final salary (or career average earnings). This will then keep in line with inflation.
 
If an employee worked and contributed into the same company pension plan for 40 years and had a salary of £40,000 p.a. when they retired they would receive £20,000 per year in retirement (i.e. 40/80 x £40,000). On top of this they could also be entitled to receive a tax free lump sum of 3 times this figure i.e. £60,000.
Defined benefit pension plans follow both general and specific rules set forth by HMRC. These stipulate the exact terms and restrictions each pension scheme must abide by to benefit from the favourable tax treatment available to pension investments by the British Government. On the whole, although they differ compared to defined contribution rules & regulations they cover the same broad areas, namely;
 

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