Defined benefit questions in R04 are mostly arithmetic wrapped in scheme jargon. Candidates who have only ever seen money purchase pensions in practice often skip the calculation detail and then lose marks on questions that require nothing more than a multiplication and a division.
The basic formula
Pension = pensionable service ÷ accrual rate × final pensionable salary
Accrual rates are expressed as fractions. A sixtieths scheme gives 1/60th of salary for each year of service, an eightieths scheme gives 1/80th, and a schemes with 1/45th accrual is generous. Public sector schemes are often expressed as a percentage such as 1/49th or 2.32%.
Worked example. Helen has 27 years and 6 months of pensionable service in a sixtieths scheme. Her final pensionable salary is £58,000.
27.5 ÷ 60 × £58,000 = £26,583 a year
Many eightieths schemes also provide an automatic lump sum of 3/80ths of salary for each year of service. On the same figures that would be 27.5 × 3 ÷ 80 × £58,000 = £59,813, alongside a pension of 27.5 ÷ 80 × £58,000 = £19,938.
Final salary against CARE
A final salary scheme uses salary at or near the date of leaving or retirement. A career average revalued earnings scheme builds a block of pension each year based on that year salary, then revalues each block until retirement, usually in line with an inflation measure plus a margin. CARE schemes protect the employer from late career salary rises and generally suit steady earners better than those promoted late.
Definitions matter in questions. Pensionable salary may exclude bonuses and overtime, and pensionable service may exclude periods of part time work on a pro rata basis.
Commutation
Most schemes let members exchange pension for tax free cash at a commutation factor. A factor of 20 to 1 means giving up £1 of annual pension for £20 of lump sum.
Worked example. Helen wants the maximum tax free cash. Her scheme uses a factor of 20 to 1 and permits cash of up to 25% of the capital value, using the standard 20 to 1 valuation. The maximum lump sum formula for a scheme with no separate lump sum is:
Maximum PCLS = pension × 20 ÷ 7 × 25% simplified to pension × 6.6667 ÷ 1
On a pension of £26,583 that gives roughly £177,220 of tax free cash, with the residual pension reduced by the commutation. The reduced pension is the original pension less the cash divided by the commutation factor, so £26,583 − (£177,220 ÷ 20) = £17,722 a year.
Whether commuting is good value depends on the factor and on the escalation applying to the pension given up. Factors below about 20 to 1 on an index linked pension are usually poor value for a healthy member, and high factors or poor health push the other way. Examiners want the reasoning, not just the number.
Revaluation and escalation
| Stage | What happens |
|---|---|
| Deferment | Deferred pension revalued in line with statutory revaluation, generally CPI subject to a cap |
| In payment, post 1997 service | Statutory increases apply, commonly CPI capped at 5% or 2.5% depending on the period |
| In payment, pre 1997 service | Often no statutory increase, other than for guaranteed minimum pension |
| GMP | Pre 1988 GMP increased by the scheme with no statutory increase, post 1988 GMP increased by the scheme up to 3% |
Guaranteed minimum pensions arise from contracting out between 1978 and 1997 and carry their own rules on payment age and equalisation, which is why transfer analysis on older schemes is complex.
Early and late retirement
Early retirement produces an actuarial reduction, commonly 3% to 5% for each year taken early, reflecting the longer payment period. Late retirement produces an actuarial increase. Ill health early retirement may be unreduced, and serious ill health with a life expectancy under a year can allow a lump sum. Scheme rules always override general expectations, so read the question.
Death benefits
- Death in service, typically a lump sum of two to four times salary plus a spouse pension
- Death in deferment, usually a spouse pension based on accrued rights, sometimes a return of contributions
- Death in retirement, a spouse or dependant pension at 50% or 66.7%, subject to any guarantee period during which the pension continues in full
Dependant pensions from a defined benefit scheme are taxable as income on the recipient, and they do not use the lump sum and death benefit allowance because they are income rather than a lump sum.
Funding and employer covenant
Trustees must obtain a triennial actuarial valuation and agree a recovery plan where there is a deficit. A technical provisions basis measures the funding target, and buyout and PPF bases give different figures again. The strength of the employer covenant is central to any transfer discussion, and where an employer becomes insolvent the Pension Protection Fund provides compensation of 100% for members over normal pension age and 90% subject to a cap for those below it, with more limited increases than the scheme promised.
Scheme pays
Where an annual allowance charge exceeds £2,000 and the pension input amount in that scheme exceeds £60,000, the member can require the scheme to pay the charge in exchange for a reduction in benefits. For a defined benefit scheme the pension input amount is the increase in the capitalised value of accrued benefits over the year, using a 16 to 1 factor, adjusted for inflation on the opening value.
The exam checklist
- Identify the accrual rate and convert it to a fraction
- Check whether service is complete years or includes months
- Check whether an automatic lump sum applies
- Apply commutation only if the question asks for cash, and state the residual pension
- Note the escalation basis, because it drives the value of any comparison
- Read the scheme rules given in the question rather than assuming the statutory minimum
Defined benefit calculations reward tidy layout. Show the formula, substitute the numbers, and state the answer with the units. In a written paper that structure earns method marks even if the arithmetic slips.