FOOL SCHOOL
Defined Benefit Schemes

September 8, 2003

Defined benefit company pensions pay you benefits based on your final salary (or an average of your salary for the last few years of your employment). Typically, the benefits will involve a lump sum and an income for life. There may well be a number of useful frills, such as life insurance and a pension for your spouse if they live longer than you.

The lump sum and income are generally expressed as a fraction of your final salary per year of service. This can seem a little complicated at first but if you take it step by step, it's not too bad. Imagine that your pension says you'll get a retirement income of 1/60 of your final salary per year of service and a lump sum of 3/80 of your final salary per year of service, and you have 20 years of service and you earn £30,000 in the year you retire.

You will stand to receive 1/3 of this (that is, 20/60) of your final salary as income - that would be £10,000 per year. (By law, the maximum you can receive is 2/3 of your salary as a pension.) You would also get 3/4 (that is, 60/80) of your final salary as a lump sum - which would be a one-off amount of £22,500. Not bad eh?

Of course very few of us with the same employer for 40 years these days, and so few people will get up to the maximum limit of 2/3 of their final salary as an annual pension.

Defined benefit schemes are generally pretty attractive for us punters because employers take the risk of the investments in the fund not growing as much as expected. The company pays money into a fund, which is managed by a board of trustees on behalf of the employees (and pensioners). These trustees have to decide on how much to invest and where to put it. They're also in charge of paying out the pensions to the pensioners.

To make sure they have enough for all the future pensioners, the trustees also have to monitor the progress of the investments. If it looks like there isn't enough in the pot to fund all the future pension commitments then they'll call on the company to give them some more dough. This is where problems can creep in. Although the pension fund is typically 'ring-fenced' from the company, meaning that the fund is still there if the company goes bust, a busted company will not be there to bale out a fund that hasn't got enough money to meet its future commitments. So, you'd be right to be a little suspicious of a large final salary pension fund attached to a small, weak company.

Companies are also acutely aware of this situation. After all, how much money do they have to put into a fund to ensure that it's safe? How sure do they need to be? Because of these problems all but the strongest companies, and those in the public sector, are stampeding to switch their pension from final salary schemes to defined contribution schemes, where the employees take the risk of the pension fund not doing well enough.

Find out more in our pension centre.