Defined benefit: What is a final salary pension and should I transfer?
How to decide whether or not to transfer your defined benefit or final salary pension into a pension pot to take advantage of pension freedom.
If you have a defined benefit (DB) pension, you may be able to transfer it into the more common and flexible type of pension, known as defined contribution.
But this is a big and irreversible decision, so it’s important to understand the risks as well as the benefits, before you proceed.
A defined benefit pension provides a guaranteed lifetime income, unlike defined contribution pensions
Defined contributions are more flexible and can help you pass wealth to loved ones, but you will need to manage your pension income
Transferring out of a defined benefit pension may give you more control over your retirement income, but you will lose valuable guarantees
If your pension is worth more than £30,000, you will need to consult a professional adviser to assess the risks first
What is a final salary/defined benefit pension scheme?
A defined benefit pension (for example a final salary or career average pension) is a type of workplace pension that provides you with a guaranteed annual income for life, based on your final or average salary and the length of time you were in the scheme.
This is different to a DC scheme, where the value of your pension depends on the amount you pay in and how well your investment performs.
With this type of pension, your income won’t be guaranteed and it will be down to you to manage it.
Although defined benefit (DB) pensions used to be widespread, they are now most commonly offered in the public sector.
DB pensions are very generous and as such, cost means many private sector employees have switched to cheaper DC schemes.
This means it’s important to think very carefully before you give yours up by transferring out.
How does a final salary pension work?
The scheme will assign you a ‘normal retirement age’, and your pension will be paid from this date. Depending on your scheme, you may be able to retire earlier on a lower income.
The amount you’re paid will depend on a number of factors, including your salary and the length of time you worked for that employer - find out more about final salary pension income.
What are the advantages of a defined benefit pension?
The main benefit of a defined benefit pension is that your income will be guaranteed for life and increase with inflation.
Although you can use the proceeds of a DC pension to buy an annuity, which pays a lifelong income, your payments may not be as high.
So long as the pension scheme itself remains funded, your DB pension income will be paid no matter how long you live.
As none of us knows how long we will live, this is a crucially important benefit. Even if you end up living till 100, you won’t run out of money.
What are the disadvantages of a defined benefit pension?
DB pensions are attractive because they pay a guaranteed income, but some people worry that they are not as flexible as DC pensions.
You can’t vary the income you take from it and, once you have taken your tax-free cash at the start, you won’t get further access to lump sums.
Another concern is that you cannot pass DB pensions onto your beneficiaries.
While your spouse or partner may continue to receive some income if you die first (as well as financially dependent children), you will not have a ‘pot of cash’ to pass on to other family members.
This could mean adult children may not receive anything when you die.
Also, there is the small risk that your pension scheme may collapse at some future point, if it is no longer adequately funded (e.g. if the employer goes bust).
In most such cases, pension benefits will still be paid to members via the Pension Protection Fund (PPF), which safeguards DB pension schemes.
However, there may be a limit to how much the PPF can guarantee.
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“Transferring a defined benefit pension is a big decision that shouldn’t be taken rashly.
As a defined benefit pension pays a guaranteed income, it’s extremely valuable compared to a defined contribution pension, where you build up a pot of money to use during retirement.
If you are considering transferring a defined benefit pension, you must legally get financial advice if it’s worth £30,000 or more.
You’ll also need to have a plan on how to invest and access your pension if you transfer it to a defined contribution one.”
What is a defined benefit pension transfer?
You may be able to ‘trade in’ a DB pension for a defined contribution (DC) pension such as a personal pension or SIPP.
This is known as a final salary pension transfer (or defined benefit pension transfer).
You can find out more about the differences between defined benefit and defined contribution pensions here.
In a final salary pension transfer, your pension provider may offer you a certain amount of money in exchange for giving up your guaranteed pension for life.
This money won’t be in the form of cash, but something called the ‘cash equivalent transfer value’ (CETV).
This sum can be invested in a pension pot from which you can then draw an income, usually from the age of 55 (rising to 57 in 2028).
Your CETV will depend on a variety of individual and economic factors, including your age, health, expected inflation and interest rates.
Example of cash equivalent transfer value (CETV)
Here is how the CETV valuation can work in practice.
Different providers may use different methods for calculating transfer values, but the following is a good rule of thumb.
Suppose you are currently 55 and have a final salary pension projected to pay you £15,000 a year from the age of 65.
A valuation might multiply this projected income by 20 to give a CETV of £300,000.
What is a good CETV?
If you were to receive this value of £300,000 CETV, how might it compare to your original final salary pension of £15,000 a year? In other words, how long might your pension last?
Because a DC pension income isn’t guaranteed, to work this out we need to make some assumptions.
How long it will last depends on how much you withdraw, the level of inflation and the performance of your investments.
For example, if you have a pension worth £300,000 and you withdraw £15,000 each year, your pension would last around 22 years. This assumes your investments grow at 3% each year after fees, and you increase withdrawals by 2% each year.
However, if you achieve investment growth of 5% after fees, your pension could last around 31 years.
You can use a pension drawdown calculator online to work out how long your pension could last.
Are all defined benefit pensions transferrable?
Not everyone can transfer their pension. If you are already retired and receiving income from your DB scheme, you won’t be able to switch to a DC scheme.
If you are a member of an unfunded pension, you won’t be able to transfer into a DC pension either. These include public sector schemes such as the NHS, teachers and civil service pensions.
What are the pros and cons of transferring a defined benefit pension?
There are many benefits and risks of transferring out of a defined benefit pension, which we’ll now explore.
The advantages of transferring a final salary pension
You can vary your income according your needs.
Access to lump sums after you have taken tax-free cash.
Any unspent pension can be inherited by your chosen beneficiaries. This is currently free of inheritance tax, but tax will be charged on inherited pensions from April 2027.
If the stock market performs well, you may end up with more money.
The disadvantages of transferring a final salary pension
Your pension income won’t be guaranteed.
You need to manage your income withdrawals to ensure you don’t run out of money.
Your pension will be vulnerable to stock market falls and could go down in value. If this happens you may need to pause withdrawals or reduce your income.
You will likely have to pay for advice on the transfer.
You will need to decide where to invest your pension fund and manage those investments yourself (unless you pay a financial adviser).
The best option for you will depend on how you personally weigh up these pros and cons.
Everyone’s circumstances are different, so just because a pension transfer worked for your colleague, it doesn’t imply that it will work as well for you.
How does a pension transfer work?
Transferring a final salary pension can be a lengthy process.
If your pension’s transfer value is over £30,000, the law requires you to seek financial advice before the transfer can be made.
Not only do you need to weigh up the pros and cons, but you also need to decide on a suitable investment strategy for your money after it has been transferred to you.
Do I need to take advice on transferring my pension?
Having money to spend now may be very appealing, especially if there is a pressing demand for it.
However, you will need to take financial advice if your pension’s transfer value is over £30,000.
Some providers further insist that you get advice on smaller transfer values as well, to protect themselves if you later decide you’ve made the wrong decision.
Taking advice helps you to weigh up your long-term needs against your short-term plans, and may reveal benefits of your pension that you haven’t considered.
Find out more about planning for retirement and pension recycling.
Get expert defined benefit pension advice
Deciding whether to transfer your defined benefit pension is a significant and complex decision that requires careful consideration of both the benefits and risks.
While a transfer might offer greater flexibility and potential for growth, it also comes with investment risks and the loss of a guaranteed lifetime income.
It’s crucial to seek financial advice to ensure you make the best decision for your individual circumstances and long-term retirement goals.
Take the time to fully understand your options, and remember that what works for someone else might not be the best choice for you.
Unbiased will match you with a financial adviser for expert financial advice on whether transferring your defined benefit pension is the right move for your retirement plans.
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