Retirement:
Defined Benefit Schemes

Defined benefit schemes can only be provided by an employer for their employees. In these schemes the benefits paid on retirement are calculated using a formula set out in the scheme rules, hence the more commonly used term of final salary scheme. The benefits as defined by the formula will usually depend on:

Your length of service whilst you were a member of the pension scheme

Your salary at retirement, or in some cases an average salary over a determined period of time

The benefit accrual rate used by the scheme typically 1/80 or 1/60 for each year of service.

Example

Mr A has worked for XYZ Ltd for 35 years and was a member of their 'final salary' pension scheme for that time. The scheme had a benefit accrual rate of 1/80. Mr A�s salary at retirement was �24,000. Under the scheme rules Mr A was entitled to the following pension benefits:

An annual pension of 35 years � 1/80 per year � �24,000 salary = �10,500

A pension lump sum of 3 � the annual pension = �31,500

Final salary schemes are generally only provided by very large employers. A particular form of final salary pensions are the statutory schemes for the Civil Service, NHS, police, teachers, local government etc. Whilst being the same as other final salary schemes in most respects they operate under separate legislation.

Final salary schemes are extremely expensive for employers to run. Over the last few years a great many employers have been closing their final salary schemes to new members and replacing them with money purchase schemes which are less expensive to fund but generally provide significantly lower benefits at retirement.

One of the reasons final salary schemes are very expensive to fund are the substantial benefits they offer such as:

early retirement

ill health retirement

enhanced benefits for dependants

pensions up to 2/3 of your salary at retirement

tax free lump sum (often 3 � your annual pension) at retirement.

Contributions

If you contribute to your employer�s pension scheme you can normally contribute up to 100% of your earnings in any year. Generally you will contribute a fixed percentage of your salary each month, for example 5%, as determined by your employer. Your employer pays the balance of the contributions to fund the scheme.

Since 6 April 2006 the maximum benefits allowable without incurring additional tax charges has changed.

The value of your benefits is subject to a maximum value determined by H M Revenue and Customs. This is the Lifetime Allowance, which is currently �1.5 million, rising to �1.8 million in the 2010-2011 tax year. To work out the notional value of your pension, HMRC will multiply your benefit by a factor of 20. Therefore if you have accrued a pension of �10,500 as per the earlier example, this would make up �210,000 of your lifetime allowance.

A factor of 10 is applied to the increase in the value of your benefits over the course of a year, to see whether the value has exceeded the annual allowance. This is �215,000 for the 2006-2007 tax year. Therefore as long as the increase in your annual pension does not exceed �21,500 you will not exceed the current annual allowance.

Note that if you exceed these limits you could be liable for considerable tax charges.

What happens if I leave the scheme?

If you leave your employer�s final salary scheme within two years of joining the scheme you will usually be able to have a refund of any contributions you have paid in that period. Otherwise your pension benefits are calculated based on your salary and length of service to the date you left the scheme (maybe with enhancements to the length of service if you are retiring due to ill health or are taking redundancy). These benefits are then held in the scheme until you reach your normal retirement age and are often called deferred benefits. They will normally be increased in line with inflation each year until you receive them. In the case of ill health retirement or any other special circumstances prescribed in the scheme rules the benefits may be paid immediately.

What happens when I die?

The actual death benefits will depend on the scheme rules but the maximum allowable benefits are:

If you die before retirement a lump sum of up to the lifetime allowance can be paid to someone you nominate. Because of the way the old legislation was laid out, this is usually a multiple of up to 4 times your earnings. There may also be a pension for dependants. This will depend on the rules of the scheme.

If you die after retirement it will depend on the scheme rules. Your dependants may be automatically entitled to a pension after your death or you may have purchased this entitlement by reducing your own pension. If they have no such entitlement they will receive nothing.