FOOL SCHOOL
Defined Benefit Schemes

November 29, 2004

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. Alternatively, you get the option to take a tax-free lump sum of 3/80 of your final salary per year of service and a reduced annual income of 1/80 of your final salary per year of service.

Let's also assume you have 20 years of service and you earn £30,000 in the year you retire.

If you go for the first option, you stand to receive £10,000 per year (20/60 of your final salary). By law, the maximum income you can receive is 2/3 of your salary.

If you opt for the lump sum, you will receive a one-off amount of £22,500 (60/80 of your final salary) and a reduced income of £7,500 per year (20/80 of your final salary).

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. We look at what happens to your pension when you change jobs in a later article.

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. They have to decide on how much to invest and where to put it. They 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 the rate that you and your employer contribute each month can be raised well in advance. There will be a set rate for what you have to contribute out of your salary each month (which is normally expressed as a percentage of your monthly pay before tax). The more your employer puts in, the less you will have to.

Unfortunately, because the risk with these schemes lies mostly with the employer they are becoming less and less common. Indeed, the closure of defined benefit schemes to new members has garnered many headlines in recent years.

In addition, in a few cases when companies have gone bust, prospective pensioners have found that their retirement income will be significantly less than they expected. This has led the government to set up the Pension Protection Fund, which is expected to launch in 2005.

> Find out more about pensions here.