Understanding a defined benefit pension

What a final salary or career average scheme actually promises, and why transferring one is rarely the answer.

If you've worked in the NHS, in teaching, for a local authority, for the civil service, or for a large employer with a long history, there's a good chance you have a defined benefit pension. In the North East, where public sector employment runs well above the national average, that's a very large number of people.

A defined benefit pension works on completely different principles from the pot-of-money pensions most people now have, and the differences matter enormously.

What it promises

A defined contribution pension is a pot. What you get out depends on what went in and how the investments did.

A defined benefit pension is a promise of income. It pays you a set amount every year for the rest of your life, usually increasing with inflation, regardless of what markets have done. The employer, not you, carries the investment risk and the risk of you living a long time.

That promise is calculated from a formula rather than a balance.

Final salary and career average

Final salary schemes calculate your pension from your salary at or near retirement, multiplied by your years of service and an accrual rate. Someone with 30 years' service on a sixtieths accrual finishes with 30/60 — half — of their final salary as an annual pension for life.

Career average schemes, which most public sector schemes moved to, build up a slice of pension each year based on that year's earnings, with each slice revalued in line with inflation until you retire. Better for people whose earnings are flat or who peak mid-career; less generous for high-fliers whose salary rises steeply at the end.

Most people with long public sector service now have a mix — final salary benefits from earlier years and career average from later ones, with rules governing how the two link together.

The features people undervalue

Because there's no visible balance, it's easy to underestimate what a defined benefit pension is worth. It typically includes:

Income for life, however long you live

Inflation protection, usually with a formula and often a cap

A spouse's or partner's pension, commonly around half, payable after your death

Ill-health early retirement terms, which can be very valuable

Death in service cover if you're still employed

To buy an equivalent package on the open market — index-linked, joint life, guaranteed — would cost an extremely large capital sum. That's the comparison to keep in mind when a transfer value looks impressive.

Transfer values, and why the answer is usually no

Most private sector defined benefit schemes will quote you a cash equivalent transfer value — a lump sum to give up the promised income and move the money into a pot you control.

These figures can look enormous. Multiples of twenty or thirty times the annual pension aren't unusual, and a £20,000-a-year pension quoting a £500,000 transfer value is the sort of number that makes people think very hard.

The regulator's position is that transferring is likely to be unsuitable for most people, and the record bears that out — reviews of transfer advice have repeatedly found large proportions of recommendations to transfer were unjustified, and significant compensation has been paid.

What you'd be giving up is the guarantee. In exchange for a large sum you take on investment risk, inflation risk, the risk of living longer than the money lasts, and the responsibility for managing all of it for the rest of your life. The large number is the price of assuming risks the employer was carrying for you.

There are situations where a transfer can genuinely make sense — serious ill health with a shortened life expectancy, no spouse or dependants combined with a strong wish to leave capital to children, or existing guaranteed income already comfortably covering all essential needs. They're the exception, not the rule.

Most public sector schemes can't be transferred at all, because they're unfunded. NHS, teachers' and civil service schemes generally don't offer a transfer value to a defined contribution arrangement. Local government pensions, which are funded, work differently.

Above £30,000, advice is compulsory. You must take regulated advice from a specialist before transferring, and the scheme won't act without evidence you have. That requirement exists precisely because of how badly this has gone wrong in the past.

This page deliberately doesn't tell you what to do about a transfer, because it isn't a decision that can responsibly be made from a web page. What it should tell you is what you'd be weighing.

What to actually check

Your normal pension age under the scheme, which may differ from your State Pension age and from other schemes you've been in

Early retirement reduction factors, if you're thinking about going before that age — these can be substantial

Whether you have benefits in more than one section of the same scheme, with different rules

The spouse's or partner's pension, and whether an unmarried partner qualifies, since some schemes require nomination

Your annual benefit statement, which most schemes issue and most members never read

If you're in a public sector scheme

Public sector pension schemes have been through significant reform, including changes to age discrimination arising from earlier reforms, which led to members being given choices about which set of benefits applies to particular periods of service. These choices can be genuinely difficult and the right answer varies by individual.

If you've received correspondence about this and set it aside, it's worth going back to. The scheme's own resources are the authoritative source for how it applies to you.

This article is for general education only and isn't personal advice. Defined benefit transfers are a specialist area, advice is legally required above £30,000, and the decision is irreversible.