Understanding defined-benefit pension schemes

01 February 2018

4 minute read

Some company pension schemes, known as defined-benefit or final salary, pay a guaranteed income at retirement. Here, we explain how they work.

Who’s it for? All investors

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.

What you’ll learn:

  • How defined benefit schemes work
  • The benefits of defined benefit schemes
  • The risks of transferring defined benefit schemes.

A defined-benefit pension scheme is a type of company pension that pays out a guaranteed income at retirement.

There are many different methods for calculating what this retirement income is. The amount may be based on your final salary, average salary during service, or the average of your last few years, as examples.

While many in the public sector, such as teachers and the police, can get this type of scheme, they are becoming increasingly scarce. Defined-benefit schemes are very expensive for employers to provide, so you’re more likely to be offered a defined-contribution scheme. With defined contribution plans, otherwise known as money-purchase schemes, there’s no such guarantee of the income you’ll receive when you come to retire, as this will depend on how much is saved, for how long and the performance of the underlying investments.

How defined-benefit schemes work

The amount of the retirement benefits is set out, or ‘defined’, in advance by the pension scheme. Your retirement income may be based on several factors.1 These include:

  • The number of years you've been a member of the scheme
  • Your final salary at retirement, on leaving the company, average salary during service, or average of your last few years’ service
  • The scheme’s rate of accrual, which is a formula used to calculate your retirement income – this may be, for example, 1/60th or 1/80th of the employee’s final year’s basic pay, multiplied by number of years in the scheme.

The longer you’ve been a member of a defined-benefit scheme, the larger the proportion of your final salary you receive at retirement.

Who manages these schemes?

Private employers’ defined-benefit schemes are set up under a trust, so that the fund is kept separate from the company’s assets. Governing trustees collectively manage the scheme. You have no control over the funds or where they are invested.

By law, in most cases trustees will be representatives from the employer, employees and professional parties.

Defined-benefit pensions aren't completely protected from the financial performance of the associated company. If the scheme doesn’t have the reserves to fund the pensions its members are entitled to and the company closes, there are likely to be reductions to the pensions that members of the scheme receive.


Defined benefit schemes often have different rules, making it important to check details with your scheme administrator. However, there’s usually a range of general benefits offered, alongside a guaranteed income. 2

  • Index-linking: Your pension is guaranteed to rise each year in line with inflation, with increases typically capped at 2.5% a year. Pensions accrued between April 1997 and April 2005 increase in line with inflation, capped at 5%
  • Death-in-service payments: Your partner and/or dependants may be entitled to a lump sum payment, and/or an income from your pension fund if you were to pass away before them. This is usually a fixed percentage of, for example, 50% of your pension income at the date of your death
  • Ill health: If you have to retire early due to poor health you may be able to receive a pension without any reductions
  • Early retirement: If you retire early you are entitled to a reduced pension. The minimum pension age you can access your private pension savings is currently 55. However, the government has announced an intention to link this age to 10 years prior to the state pension age. If this becomes law, the minimum pension age will increase in the future. You may also be able to defer taking your pension.

A lump sum

You’re normally able to take 25% of your pension savings as a tax-free lump sum. However, this will reduce the amount of income received from the remainder of your retirement pot, on which you’ll have to pay tax at your marginal rate. Remember, however, that tax rules can change at any time in the future, and their effects on you will depend on your individual circumstances.

Calculating your lump sum entitlement is complicated with defined benefit schemes. Contact your particular scheme to ask how much you may receive under its particular rules3 and if you’re not sure, seek professional independent financial advice.

Pension freedoms and defined benefit schemes

The government introduced changes to Britain’s pension system, which took effect from April 2016, giving savers more freedom to decide how to spend their defined contributions as they wish. Savers can choose to access their pension regularly if they want to, dipping into their pot to provide a retirement income or pay major expenses. Final salary schemes aren’t strictly included in the reforms, although savers who want to access their pension savings could transfer their final salary pensions into a defined contribution plan.

However, giving up benefits from these schemes is generally not considered a sensible option and is unlikely to be in your best interests.

Many of these schemes provide generous ill-health and early-retirement pensions for spouses and dependants upon death, which are usually excluded in a personal pension such as a self-invested personal pension. Transferring out will also see you giving up a guaranteed income in retirement.

It’s now a legal requirement to have financial advice before you transfer out from one of these schemes. Even with advice, some providers may not accept them as a transfer and we won’t accept transfers into our self-invested personal pension (SIPP) from defined-benefit schemes.

The value of investments can fall as well as rise. You may get back less than you invest. Tax rules can change and their effects on you will depend on your individual circumstances.

You may also be interested in

What is a SIPP?

If you’re looking for greater control over how your retirement savings are invested, and you have investment expertise and the necessary time then a self-invested personal pension (SIPP) could be worth considering.

Consolidating your pensions

You may have built up several pension pots from various employers during your working life. It’s possible to bring these pension funds together in one place. This is called consolidating your pensions, or pension switching.

Types of pension

Pensions can seem complex and daunting, especially if you’re new to them. But there are lots of options available to suit individual needs and circumstances. We take a look at the main types of pension and explain how they work.