How is defined benefit pension income calculated?

Based on your salary and how long you’ve worked for your employer, your defined benefit pension provides a guaranteed income throughout your retirement.

In this guide, we'll walk through how defined benefit pension income is calculated, explaining the key factors that determine what you'll receive and how your pension can increase both before and during retirement.

If you have a defined benefit pension insured by Canada Life, you can find out more about your pension here.

What factors determine your defined benefit pension income?

Your defined benefit pension income is calculated using a formula set by your pension scheme. While the exact calculation can vary between schemes, it typically includes three main factors:

• Pensionable salary: The elements of your pay that count towards your pension.
• Years of service: How long you've worked for your employer.
• Accrual rate: The fraction of your pensionable salary you'll get as pension income for each year of service.

Understanding these factors helps you see how your pension builds up over time and what you can expect when you retire.

What is pensionable salary?

Your pensionable salary is the amount of your earnings that your pension scheme uses to calculate your benefits. Your scheme determines which type of pensionable salary applies to you – you can't choose this yourself.

There are two types:

• Final salary: Your pension is based on your earnings near the end of your employment. This is usually your salary in your final year, or an average of your last few years, depending on your scheme's rules.
• Career average (CARE): Your pension is based on your average salary for each year you've worked in the scheme. Each year's pensionable earnings are revalued (increased) annually, often in line with inflation, to maintain their value.

It's worth noting that pensionable salary may not include all elements of your pay. Depending on your scheme's rules, things like bonuses, overtime or certain allowances might be excluded.

What is an accrual rate?

Accrual rate is the proportion of your earnings you'll get as a pension for each year you're in the scheme. It's usually expressed as a fraction, with common rates being 1/60th or 1/80th.

A 1/60th accrual rate means you'll build up 1/60th of your pensionable salary as pension income for each year of service. The lower the denominator, the more generous the pension. A 1/60th accrual rate builds up benefits faster than a 1/80th rate. For example:

• With a 1/60th rate and 30 years of service, you'd get 30/60ths (half) of your pensionable salary.

How defined benefit pension income works

While the exact calculation used to work out your defined benefit pension will depend on your scheme, it will likely be based on this formula:

Years of service ÷ accrual rate × pensionable salary = annual pension

Let's look at a practical example.

If you've been in a defined benefit scheme for 10 years with a salary of £30,000, and the scheme accrual rate is 1/60th for each year of service, your annual pension would be calculated like this:

This means you'd get £5,000 every year (around £417 per month before tax).

How your pension increases before retirement

To protect the value of your pension benefits, most schemes apply annual increases, known as ‘revaluation’. This helps your pension keep pace with rising prices over time.

Revaluation is particularly important if you leave your employer before taking your pension. When this happens, your pension becomes ‘deferred’.

How your deferred pension increases depends on when you built up the benefits and your scheme's rules. Typically, increases are linked to inflation measures like the Consumer Prices Index (CPI), often capped at 5% for pensions earned before 2009, or 2.5% for pensions earned after.

Revaluation means that even if you leave a scheme many years before retirement, your pension will be worth more in real terms when you come to take it.

How your pension increases in retirement

Once you start getting your defined benefit pension, many schemes continue to increase your payments annually. This is known as ‘indexation’, and it helps protect your income against inflation throughout retirement.

How your pension increases depends on when you built up your benefits:

• Before April 1997: The pension you earned up to that date does not have to increase in line with inflation by law. Whether it goes up (and by how much) depends on your scheme’s rules and could even be zero.
• After April 1997: The pension you earned from that point onwards must, by law, rise each year with inflation up to a limit. This is typically up to 5% a year for pension earned between 1997 and 2005, and up to 2.5% a year for pension earned after 2005. Your own scheme might promise more.

To find out more about what increases to your annual payments to expect, speak to your financial adviser or pension provider.

Factors that influence your pension amount

The age at which you retire affects how much pension you get. If you take your pension earlier than your scheme's 'normal retirement age', you'll typically get a reduced amount because it'll be paid for longer.

Taking it later usually means a higher income. And if you take a tax-free lump sum when you retire, your annual pension income will be lower, as the scheme reduces your regular payments to account for the lump sum.

To find out how your retirement age will affect your income, speak to your financial adviser or pension provider.

Tax and defined benefit pension income

Your defined benefit pension income is taxed in the same way as employment income. This means it's added to any other income you get, and you'll pay Income Tax based on your total earnings.

When you start taking your pension, you may be able to take up to 25% of your pension as a tax-free lump sum, depending on your scheme. The remaining 75% is then used to provide your regular pension income, which is subject to Income Tax. Some schemes allow you to take your entire pension as a lump sum, though the same 25% tax-free limit applies and the rest is taxed as income.

It's important to understand the tax implications of taking a lump sum, as it reduces your guaranteed income for life. You might find it helpful to speak with a financial adviser to help you work out the most tax-efficient approach for your circumstances.

What happens to my income when I die?

Most defined benefit schemes continue to pay a pension to your spouse, civil partner or dependants after you die, though the amount is usually reduced compared to what you were getting.

The exact benefits available to you and who qualifies differ between schemes. Your financial adviser or pension provider can confirm the details of your scheme.

Learn more about defined benefit pensions