Introduction
What is a defined benefit scheme?
Most defined benefit schemes provide benefits based upon 4 key elements:
- the length of the pensionable service you are credited with as being an active member of the scheme
- your pensionable salary
- the formula or rate of ‘accrual’ which uses service and salary to work out your pension
- the circumstances under which benefits are taken from the scheme (retirement, early payment, early leaver, ill-health, death etc).
Your pension scheme will use a formula, to calculate your pension benefits using these elements. The formula (and the definitions for each part of it) will be set out in the Scheme Rules.
The two most common forms of defined benefit scheme are:
- ‘final salary’ schemes where your pension is based upon your ‘final pensionable salary’ in the years immediately before you take your pension, and
- ‘career average revalued earnings schemes’ (CARE schemes) where your pension is based upon your ‘average pensionable earnings’ throughout the whole of the time you are an active scheme member.
Because both types of scheme use your pensionable salary as one part of the formula in order to calculate your pension, they are both commonly referred to as ‘salary related’ schemes, but there is a significant difference between the two.
Example of a ‘final salary’ formula:
length of pensionable service x final pensionable salary
accrual rate
A ‘final salary’ type defined benefit scheme would use your pensionable earnings near to the date when you draw your pension benefits. Different schemes use different definitions, so it is the definition of your ‘final pensionable salary’ (or ‘final pensionable earnings’) that is important in this type of scheme. A common example of ‘final pensionable salary’ would be your pensionable earnings in your last year as an active member of the scheme.
Example of a ‘CARE scheme’ formula:
length of pensionable service x average pensionable salary
accrual rate
A CARE scheme uses your average pensionable earnings over the lifetime of your active scheme membership. It is therefore, the definition of your ‘pensionable earnings’ that is important in this type of scheme. Usually, the pensionable earnings used are increased (called inflation adjustment) to allow for inflation between the date they were received and the date on which benefits become payable. The ‘inflation adjustment’ could be structured in many ways, but would be based upon one of the Prices Inflation Indexes (such as RPI or CPI) or in a generous scheme, on Average Earnings increases.
A defined benefit scheme provides benefits that are based upon a set of rules which relate to particular members of a particular scheme, at a specific time. The key feature of defined benefit schemes, is that a specific amount of pension benefit will be paid to the members in specific circumstances.
It is not true that defined benefit schemes provide a guaranteed retirement pension. The pension benefit paid will depend upon many factors, with the most important being the scheme’s ability to pay benefits to members as they fall due. If the employer’s business fails, it is likely that benefits will be reduced for some, if not all members (although Public Sector schemes are different in this respect). For further information on this, please refer to our Module, How secure is my pension?
An example of calculating pension benefits in a ‘final salary’ defined benefit scheme for an active member retiring from service:
Jennifer Grant is an active member of her pension scheme, and is retiring from work. She has been a member of the scheme for 20 years and her final pensionable salary (which is what her pension is based upon) is £30,000 p.a. She earned a pension equal to 1/60th of her final pensionable salary for each year she was in pensionable service (the ‘accrual rate’).
Pensionable Service, 20 years
Final Pensionable Salary, £30,000
‘Accrual rate’, 1/60th
Her pension will be: 20 years x £30,000
60
= £10,000 p.a.
You can receive different benefits dependent upon the circumstances under which they are taken from the scheme and typically these would include:
- The scheme may pay a reduced pension if your take your pension benefits early, rather than at normal pension age.
- If you take benefits later, they may be enhanced.
- Ill-health benefits could be completely different (enhanced, reduced), depending on the scheme rules.
- Your dependants may receive different benefits on your death, in each of the above examples.
What is an accrual rate?
The ‘accrual rate’ is the rate at which you build up pension benefits whilst a member of the pension scheme.
It is most commonly expressed as a fraction, such as 1/30th, 1/60th, 1/80th, 1/120th etc. The lower the bottom number, the better the pension benefit you will receive for an equivalent amount of pensionable service e.g.
Example 1, using a 1/60th ‘accrual rate’
Pensionable Service, 20 years
Final Pensionable Salary, £30,000
‘Accrual rate’, 1/60th
Pension: 20 years x £30,000
60
= £10,000 p.a.
Example 2: using a 1/80th ‘accrual rate’
Pensionable Service, 20 years
Final Pensionable Salary, £30,000
‘Accrual rate’, 1/80th
Pension: 20 years x £30,000
80
= £7,500 p.a.
The ‘final pensionable salary’ used in these examples can apply to either a final salary scheme or a career average scheme.
An accrual rate can sometimes be expressed as a percentage e.g., 1.25% (which is simply another way of saying 1/80th in this example). So, in a final salary scheme for example, you may accrue 1.25% of your final pensionable salary for each year of pensionable service.
What benefits are provided by a defined benefit scheme?
The benefit that your pension scheme provides can be designed in whatever way the sponsoring employer wishes.
The only limit to the creativity in what the scheme is attempting to achieve, is how much your employer and you are prepared to pay - and the extent that both of you are prepared to commit to keeping it going.
As time has passed, these schemes have changed with the needs of members, of employers (in attracting new employees) and of government.
A defined benefit scheme can provide an income (commonly referred to as a pension) or an income and a lump sum.
Many schemes include the option which allows you to exchange part of your pension for a tax-free lump sum payment. This is called ‘commutation’ of your pension.
Some pension schemes, notably many of the public sector schemes such as the NHS, Teachers, Local Government and Civil Service schemes, provide the tax-free lump in addition to the pension – i.e. there is no exchanging part of your pension for a lump sum, although the pension part of the benefit will normally be lower than if this design was not used.
Other benefits may include a spouse’s, civil partner’s or other dependants’ pension, payable in the event of your death. Most schemes also provide a lump sum death benefit.
Did I have to join my pension scheme?
You are not normally obliged to join, but your employer may automatically enrol you in the pension scheme. Alternatively, you may be required to work for your employer for a specified period, before you are eligible to join the pension scheme (e.g. 12 months). For more information see our Quicknote, Did I have to join my pension scheme?
What earnings are used in calculating my pension?
What counts towards ‘pensionable service’?
The Rules of your pension scheme will define what period of your actual service will be classed as your pensionable service. It is not necessarily the full period of your employment as you may have commenced work before you were eligible to join the pension scheme.
When can I get my pension benefits?
Benefits will normally be payable to you when you reach your scheme’s normal pension age or Normal Retirement Date. This is important as it is the date at which you would normally have been expected to start to draw your pension benefits without the consent of the employer or the Trustees.
Depending upon the rules of your scheme (not all schemes allow these alternatives), you may also be entitled to receive benefits at other dates such as:
- Early retirement
- Retirement due to ill health
- Terminal illness
- Late retirement (where you choose to work beyond normal pension age).
Can I calculate these benefits now?
If you are an active member your regular benefit statement should tell you what you may get at normal pension age based upon your current earnings.
These figures however, do not guarantee what benefits you will actually receive at normal pension age as circumstances can change in the future, but they should help you plan for your retirement.
If you cannot find your benefit statement and want to know how much your benefit would be at alternative dates, you should contact your scheme’s Pension Manager.
What are my benefits ‘worth’?
You know that your pension benefits will be calculated based on your pensionable salary, the number of years service in the scheme, and the ‘accrual rate’, but this can only provide an approximate figure of what to expect at retirement. Until the final calculation is made at the time you are due to take your benefits, any other figures you receive will be just an estimate.
Example: estimating an active member’s pension at retirement age
Paul is 55 and an active member of his employer’s final salary defined benefit scheme. He has already built up 15 years service in the scheme, and is 10 years away from normal pension age, 65, when he plans to retire. He could therefore build up a total of 25 years pensionable service (15 past + 10 future). His current salary is £38,000 p.a. although his pension is actually based upon his pensionable salary which is £35,000 p.a. He earned a pension equal to 1/60th of his final pensionable salary for each year he was in pensionable service (the ‘accrual rate’).
Paul expects to receive increases to his pay which average 2.5% p.a. over the next 10 years. He estimates his final pensionable salary at age 65 will be £44,803 p.a. (£35,000 plus 10 years increases at 2.5% p.a.)
So, at age 65, he estimates his pension will be:
Pensionable Service 25 years
Final Pensionable Salary £44,803 p.a.
‘Accrual rate’ 1/60th
Pension: 25 years x £44,803
60
= £18,668 p.a.
The real ‘value’ of your benefits may depend upon a lot of other factors which are personal to YOU. For example, because of your health you may place a high ‘value’ on any dependants’ benefits which the scheme provides on your death.
Other benefits may be much more ‘intangible’, such as your preference for having a financially secure retirement, and how you achieve this.
How secure are my benefits?
In a private sector defined benefit scheme, your benefits are only as secure as the funds which have been set aside to pay for the benefits, and the employer’s willingness and ability to continue to support the scheme. After you retire, your benefits will be more secure, but, as the saying goes, nothing in life is guaranteed (except taxes and death). With the introduction of the Pension Protection Fund you may be entitled to ‘compensation’ if the sponsoring employer goes into receivership and your scheme meets the qualifying criteria set to allow compensation to be paid to scheme members.
In a public sector defined benefit scheme, such as those for nurses, teachers, local government and civil servants, benefits are generally regarded as ‘safe as houses’. Some of these schemes, such as the Local Government Pension Schemes, are ‘funded’ in the same way as private sector schemes but employer contributions come from local taxation such as Council, Local Business Taxation, and through Central Government settlements which come from the taxpayer. These particular schemes would not qualify for the Pension Protection Fund, as it would be expected that the Treasury would one way or another, bail out any such scheme that suffered serious problems. This is clearly a highly political area.
Can my benefits and contributions be changed?
Inevitably, this can happen. Any changes in pension legislation might mean that the scheme has to change. Otherwise, there are legal requirements that certain changes can only be made after consulting some classes of members. Any improvements which don’t involve you in a higher cost would not require your consent. You would however, be told of any change.
A scheme must take care that where it grants extra benefits for one class of member, that it does not diminish the security of others. If this is a significant risk, the Trustees should request specific financial funding or guarantees to cover the extra benefits.
‘Section 67’ of the Pensions Act 1995 is legislation that says the benefits of existing scheme members may not be adversely affected by an amendment in relation to those benefits earned before the date of change.
Benefits can be reduced or contributions increased for the future. If you do not consent to the changes, you may have to leave the scheme.
What rights do I have as a member to ensure the scheme is run properly?
Any member can seek election to become a Trustee of their pension scheme, where there is a Board of Trustees. A Trustee is responsible for ensuring the scheme operates according to all the Scheme Rules.
If you are unhappy about any aspect of the scheme contact the Trustees, and if they do not satisfy you having formally pursued the Internal Dispute Resolution Procedure, you can contact The Pensions Ombudsman or The Pensions Regulator depending on your problem. Also, see our list of Useful Contacts.
Summary & Key Points
When making enquiries about your pension benefit it is very important that you make it clear that you are an active member of the scheme rather than a preserved member or pensioner member. Active, preserved and pensioner are different classes of membership of a pension scheme and any definitions and paragraphs contained within your Scheme Rules or scheme literature relating to any benefit may differ considerably between these categories.
For each pension benefit, you need to consider the following items:
- Is your pension scheme a defined benefit pension scheme? If yes, is it final salary or career average revalued earnings?
- How much of your earnings, including any bonuses, overtime, allowances and benefits in kind, go towards your pensionable earnings? Will your earnings reduce the closer you get to retirement?
- What is the formula or ‘accrual rate’ used in calculating your pension benefit? Has this changed at any time during your membership of the pension scheme?
- Is there any reduction to the amount of earnings that go to calculating your pension benefits?
- What pension benefits are provided by your pension scheme? Pension, lump sum, death benefits, ill-health benefits, early payment, pension increases?
- Keep informed. Your scheme may modify benefits and Rules. Legislation may change. Your circumstances may alter.
- Rules differ from scheme to scheme and are wide and varied in content. Don’t assume that what applies to one of your pension schemes will necessarily apply to others that you may have.
- HMRC impose rules which registered pension schemes must conform to.
People seldom have identical pensions and you should avoid drawing comparisons with colleagues whose circumstances may at first appear the same but could emerge as having significant differences.
This Factsheet forms part of our Module Types of Pension Scheme and should be read alongside the other Factsheets and Quicknotes in the series.
This is not an authoritative document. Seek professional advice from an appropriately experienced and qualified adviser.
What is a defined benefit scheme v3.0 - Active
Last updated 14/12/2006
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