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Friday, August 29, 2014

Defined benefit – Who benefits the most?

Advantages of defined benefit retirement plans
Annuity purchases are not required for defined benefit pension plans

With this type of pension, you will receive a set, guaranteed level of income without the need to purchase an annuity. This will relate directly to your salary when you retired and the amount of time that you paid in to the scheme. This is where the common name for this type of pension comes from: you receive a defined amount of benefit, based on your final salary. There is no need to purchase an annuity.

It works on an accrual basis over the period of time you hold the pension plan. This takes the form of a fraction, and will most commonly be 1/60 or 1/80. For every year you pay into the scheme, this fraction will be added to the amount of your final salary that you receive in your pension.

Estimating your pension

To work out how much of your final salary you will receive, multiply the fraction by the number of years you have paid in. For example, if the accrual rate is 1/60 and you pay in for 30 years, you will receive 30/60 (or more simply half) of your final salary as an annual income from your pension.

Another form of defined benefit pension, called a career average pension is also available although it is less common. This works in a similar way but relates to your average salary across the whole of your career rather than being based on your final salary.

Recent trends for defined benefit pension schemes

This type of pension plan has recently fallen out of favour with many employers and become significantly less common than it once was. There are two reasons for this. The first is that this type of plan has always been more attractive for employees than employers. This is because all the investment risk is taken by the scheme, and it is obligated to meet a level of payout that was set far in advance rather than simply handing out a final pot for an annuity purchase. The employee, meanwhile, benefits from almost perfect stability. For more information on pensions stability and risk, more information can be found on the Aon Hewitt website.

The second reason for the decline of final salary pensions and the key trigger for the final shift away from them, is that they are becoming more expensive. People are living longer, and unlike annuity-based schemes, the payout level of a final or average salary pension is not subject to any adjustment. This means that more money has to be paid out over a longer period than with most other schemes.

Who benefits the most?

Those who are taking out a defined benefit scheme earlier in their career stand to benefit more. Those who are presented with the option to take out a new scheme to supplement their retirement income later on will have fewer years for accrual, while those who hold the scheme for longer will have time to build up a healthy retirement income.

It can also benefit those who wish to be protected against certain eventualities. For example, if you die before reaching pensionable age while holding this type of pension, your spouse or dependants will be eligible for death in service payments. You can also receive a full pension if ill health forces early retirement on you, or a reduced pension for voluntary early retirement.

Image license: Chris Potter; "Education Retirement", CC BY 2.0