Defined benefit: What is a final salary pension and should I transfer?

If you have a defined benefit (DB) pension, you may be offered the option to transfer it into the more common type of pension, known as defined contribution.

This is a big and irreversible decision, so it’s important to understand exactly what it means and the pros and cons.

What is a final salary/defined benefit pension scheme?

A DB pension (also known as a final salary pension) is a special type of workplace pension.

Instead of building up a pension pot over time, it provides you with a guaranteed annual income for life based on your final or average salary.

DB pensions are most often provided by the public sector and government employers.

Some private sector employers do still offer them as they are an attractive pension. DB pensions are typically more generous than other types of pensions, so you should think carefully before transferring.

How does a final salary pension work?

When you are a member of a DB or final salary pension scheme, your employer pays into a central fund on your behalf (unless your scheme is directly funded by the taxpayer).

The scheme will assign you a ‘normal retirement age’, and your pension will be paid from this date.

The amount you’re paid will depend on a number of factors – find out more about final salary pension income.

What are the advantages of a defined benefit pension?

DB pensions are often seen as more generous as it would take an above-average defined contribution (DC) pot to be able to buy an annuity that pays you the same amount as a DB scheme.

What’s more, the payouts from a DB pension are guaranteed for the rest of your life.

So long as the pension scheme itself remains funded, your 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?

Despite the attractions of a DB pension, in some ways, it is not as flexible as a DC pension pot.

You can’t vary the income you take from it, nor draw out larger lump sums, apart from the tax-free lump sum offered by some final salary schemes.

Also, this kind of pension cannot be inherited by your beneficiaries.

If you die prematurely, there may be a widow’s pension for your spouse, but most of the benefits will be lost, and your children may receive nothing.

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.

What is a defined benefit pension transfer?

You can ‘trade in’ a DB pension for a fixed-size pension pot of the kind found in defined contribution (DC) pensions.

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.

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 around £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 pot worth £300,000 and you withdraw £15,000 each year, your pension could last around 22 years. That 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 your pension is “unfunded” with no central fund, you also can’t transfer your pension to a DC scheme.

Public-sector schemes (such as an NHS pension) are ‘unfunded’, meaning they are supported directly by the taxpayer. If you're in an 'unfunded' public sector pension scheme, you can only transfer your pension to another defined benefit scheme and not to any other type of scheme.

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 may be able to access your pension from an earlier age
• You can vary your income as you wish
• Any unspent pension can be inherited by your 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

• You may achieve a lower pension income because DB pensions are typically more generous.
• Your pension income won’t be guaranteed.
• Your pension wealth could run out, especially if you live for a long time or the stock market underperforms.
• Your pension pot will be vulnerable to stock market falls and could go down in value.
• You will likely have to pay for advice on the transfer.
• You will be responsible for managing your pension from now on and make decisions about where to invest your pension.

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 financial 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.