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What Is A Defined Benefit Pension Plan?

Richard Beardsworth Pension Expert

By Richard Beardsworth.

Independent Financial Advisor

More Reading on Company Pensions...

The defined benefit pension plan is just one of many different kinds of pensions in which a UK worker can participate. Unlike some other types of pensions, defined benefit schemes are always workplace pensions. They are offered by employers as a benefit designed to attract and retain high-quality workers. The bad news about defined benefit pension plans is that they are being quickly phased out because of the high costs associated with maintaining them.

The term 'defined benefit' is derived from the fact that the beneficiary receives the guarantee of a certain level of retirement income when enrolling. Eventual pension payments may increase with the cost of living, but they will never decrease for the life of the pensioner. Furthermore, eventual payouts are not tied to investment performance in any way, shape, or form.

Defined contribution pensions are just the opposite. Pension members are not guaranteed any specific payout upon retirement, as the eventual value of their pension pots is determined solely by the performance of their investments. Although rare, it is entirely possible for a defined contribution pension member to receive less in actual payments than the contributions made over time.

Determining Pension Benefits

A defined benefit pension plan will be based on one of two models. The first model is known as 'final salary'. This model is based on the salary the employee was making at the time of retirement. This is not to say the employee will receive the same amount of annual income as a pensioner, only that the individual's final salary provides the basis for calculating payments.

The second model is known as 'salary average'. Under this model, the employer can choose to either average earnings across the employee's entire career or consider just those earnings received in a specified window of time. More often than not, this model relies on career earnings.

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Calculating eventual payments involves three important factors, regardless of which model is chosen:

  • Pensionable Earnings – The first component is the total of pensionable earnings as determined by the base calculation we explained previously. The base is the final salary being earned the time of retirement, or an average based on career earnings or a specified amount of time.
  • Pensionable Years – The total number of years worked in which pensionable earnings were received is considered a worker's pensionable years. This component is also known as 'years of service' in some circles.
  • Accrual Rate – Very few defined benefit pension plans, if any at all, pay a full salary at retirement. Instead, they use an accrual rate that takes into account pensionable earnings and years. The accrual rate is essentially a fraction of pensionable earnings applied to the total years of service.

For purposes of illustration, assume a pensioner retires with a defined benefit pension plan paying a 1/60 accrual rate on average earnings. Then assume average earnings of £40,000 over a 30-year career. The following mathematical formula is applied:

  • £40,000 x 1/60 = £666.66 in accrued earnings
  • £666.66 x 30 years of service = £19,999.80 in annual payments.

Annual pension payments would essentially work out to £20,000. Of course, the average defined benefit pension plan is indexed to inflation. As the cost of living goes up, so due pension payments. Most defined benefit plans limit inflation index increases to 2.5%.

Additional Benefits of Defined Benefit Plans

Defined benefit pension plans are superior to their defined contribution counterparts just in their retirement income guarantee alone. However, these plans tend to offer other benefits that make them truly special. So special, in fact, that defined benefit pensions are often referred to as 'gold-standard' pension plans.

Some of those additional benefits are as follows:

  • Full Pension Benefits – A worker forced to retire early due to ill health is usually provided full pension benefits for as long as he or she lives. The medical condition forcing early retirement must be documented in order to receive full pension benefits.
  • Partial Pension Benefits – Many pension plans offer partial benefits to those who choose to retire early but without legitimate medical need. The same formula applies to early retirement as would apply to working until full retirement age. This benefit does not apply to those who retire prior to the age of 55.
  • Death in Service Payments – The pensioner who dies before reaching pensionable age is able to pass on his or her defined benefit plan to a surviving spouse, child, or another relative. A pension is never truly lost due to premature death.
  • Provider Benefits – From time to time, a pension provider will offer additional benefits designed to encourage people to remain in the scheme throughout retirement. The benefits may include things such as additional provider contributions, life insurance, and investment opportunities. These additional benefits are likely to be lost if the pension member decides to transfer out of the plan.

It should be clear that the combination of guaranteed income and the additional benefits offered by defined benefit pension plans makes these plans very much appreciated by those who have them. If you are among those UK workers enrolled in such a scheme, you are among a shrinking group of very fortunate workers.

Accessing a Defined Benefit Pension Plan

It is generally assumed that members of defined benefit schemes will only access their pension plans through the normal channels at retirement. This means receiving monthly or annual pension payments commencing on the date the individual reaches pension age. The only exception here is that of retiring between the age of 55 and the state pension age, under which partial benefits may be accessed.

It must be made clear that defined benefit schemes are not eligible for the same freedoms afforded defined contribution schemes through pension reform. There is two good reasons for this. First, the government does not want defined benefit members to lose that guaranteed income in exchange for the temporary benefits of being able to access cash early. Second, allowing defined benefit pension plans the same freedoms could jeopardise schemes that are unfunded.

An unfunded pension scheme is one that receives no contributions from either the employer or employee. Payments are made to pensioners as though they were still salaried employees. Can you imagine what would happen to an organisation with an unfunded pension scheme suddenly subjected to the flexibilities of reform?

The vast majority of unfunded defined benefit pension plans are government entities. They simply do not have the money that would be necessary to allow pension savers the freedom to access large sums of money prior to reaching state retirement age.

Transferring a Defined Benefit Pension

Members of defined benefit pension plans do have an available workaround if they believe it is necessary to access their cash early. They can transfer out of their current scheme and into a new defined contribution scheme such as a stakeholder pension, SIPP, or QROPS. Having said that, doing so is not easy. Pension administrators are required by law to make absolutely sure members know exactly what they are doing and are willing to accept the consequences, before approving the transfer.

Transfers typically come with expensive charges that may significantly diminish the overall value of the pension plan. Furthermore, the transfer value of a defined benefit pension is rarely close to its full value should a pensioner decide to remain in the scheme. In essence, transferring out of a defined benefit plan means the recipient will get substantially less as a result.

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A defined benefit pension plan is a very good retirement tool to have. If you participate in one, we urge you to keep it and enjoy its many benefits during your retirement years. You should only consider transferring out if doing so is an absolute and unavoidable necessity.

If you are unsure about your current provision, or are looking to discuss any aspect of pensions, contact our team of pension transfer advisors. Our panel consists of fully qualified, FCA regulated and independent advisors. We can advise you on the best course of action using extensive knowledge of the market to compare fund and benefits, and provide recommendations on the products that are best suited to you.

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