Defined benefit: What is a final salary pension and should I transfer?
Updated 19 February 2020
If you have a defined benefit (DB) pension, you may be offered the option to transfer it into the more common type of pension (defined contribution). This is a big decision and an irreversible one, so it’s important to understand exactly what this means, and what the pros and cons for you might be.
What is a defined benefit pension scheme?
A defined benefit or 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 (hence the name).
DB pensions are most often provided by the public sector (health, education etc) and government employers. Some private sector employers do still offer them, however. Historically they have been seen as a very attractive kind of pension.
How does a final salary pension work?
When you are a member of a DB / 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 DB pension?
DB pensions are often seen as more generous, because 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.
What are the drawbacks of a DB 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 nothing passes to your children.
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 DB 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).
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 from the age of 55.
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 £12,000 a year from the age of 65. A modest valuation might multiply this projected income by 25, to give a CETV of around £300,000. A more generous valuation might use a multiplier of 30 or even higher, to give a CETV of £360,000 or over.
Is my CETV good value?
If you were to receive this ‘low’ value of £300,000 CETV, how might it compare to your original final salary pension of £12,000 a year? In other words, how long might your pension last?
You can see that even with no growth at all, you could withdraw £12,000 a year from £300,000 for 25 years. If you were to achieve a mere 1 per cent average growth on your pension pot, you could withdraw £12,000 a year for over 28 years before your money ran out.
If you were to achieve slightly higher growth on your pot – say 2 per cent – then your pot would last over 34 years at the same rate of spending. Alternatively, you might take a higher income – e.g. £15,000 a year for 25 years.
This sounds like great news – but there is an important catch. No level of growth is guaranteed when you take your pension in this way, and there may be times when your pot actually falls in value due to dips (or crashes) in the stock market. Generally, you will see growth over the long term. But a stock market crash can seriously dent the size of your pot in the short term, which can affect both the size of your income and the lifespan of your pension savings.
The choice you face is essentially this: having more money to spend now, versus having a guaranteed income for the rest of your life – which may work out as more money or less, depending on how long you live and how the stock market performs.
Are all DB pensions transferrable?
Not every DB pension is transferrable. Private sector schemes, and some public sector ones, will be ‘funded’ – that is, supported by a central fund. This is the only kind from which you can transfer. Other public-sector schemes (such as the NHS pension) are ‘unfunded’, meaning they are supported directly by the taxpayer. You can’t transfer out of this kind of pension.
Final salary pension transfers – the pros and cons
What are the possible benefits and risks of transferring out of a defined benefit pension? Let’s compare them.
Advantages of transferring a final salary pension
- You can access your pension from an earlier age
- You can vary your income as you wish
- Unspent pension can be inherited by your beneficiaries, free of inheritance tax
- If the stock market performs well, you may end up with more money
- Your pension is not at risk if your former employer becomes insolvent
Disadvantages of transferring a final salary pension
- You’re trading a guaranteed income for pension pot that may run out
- Your pension pot will be vulnerable to stock market falls
- You will probably have to pay for advice on the transfer
- You will be responsible for managing your pension from now on
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 pension transfer worked for your colleague, doesn’t imply that it will work as well for you.
How a pension transfer works
Transferring a final salary pension can be a lengthy process. 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.
Here you can read an example of a defined benefit pension transfer to show you the steps involved.
Is pension transfer right for you?
Having money to spend now may be very appealing, especially if there is a pressing demand for it. However, if your pension’s transfer value is over £30,000, the law requires you to seek financial advice before the transfer can be made. 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. Here's a real-life example of such advice in action:
Find out more about planning for retirement.
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