Below is an Overview of final salary pension schemes in the UK, by Kevin O’Neill. Kevin is a Financial Planner and Pension transfer specialist at O’Neill Financial Services a trading style of Camargue Wealth LTD, based in Cheadle, Cheshire. The following is for information purposes only and should not be received as legal advice or financial advice.
Remember: Transferring out of a Final Salary scheme is unlikely to be in the best interests of most people. The value of pensions can fall as well as rise. You may get back less than you invested.
- Introduction: What Is A Final Salary Pension?
- Example of a Final Salary Scheme
- Final Salary Schemes: The Different Types
- Can I Take a Lump Sum from my Final Salary Pension?
- What Happens if my Employer Goes Bust?
- Pros of a Final Salary Pension
- Cons of a Final Salary Pension
- Final Salary Pension Benefits: A Summary of How They Work
- Transferring A Final Salary Pension Scheme
- Video: What’s Involved With A Pension Transfer?
Introduction: What Is A Final Salary Pension?
A final salary pension is a particular type of “defined benefit” pension, where your employer pledges to pay you an agreed income when you retire.
This income is said to be “guaranteed”, and the amount you get will be determined by a set of criteria outlined in your scheme.
These criteria typically include:
- Your “final pensionable salary” (FPS). This can refer to one of two things. Either it refers to your income at the time you retire. Or it could refer to your average earnings across a defined period of time covering your career (e.g. the average of your last 3 years pensionable salary). Your FPS should be defined in your pension scheme.
- Your years of service. I.e. How long you paid into the scheme.
- Personal circumstances. For instance, did you retire early or leave work early due to ill health?
- Accrual rate. This is the rate at which you built up benefits whilst a member of your pension scheme. Often, this is shown as a fraction – such as 1/80th or 1/30th. Ideally, a lower denominator (bottom number of the fraction) means a better deal for you.
This makes a final salary pension very different from a “defined contribution pension” – the other main kind of employer pension. Under this scheme, you build up a “pension pot” over time by setting some of your own money aside each month. Your employer also will make a contribution to your pension – e.g. 3% of your contributions.
Under a final salary scheme, you do not build up a pension pot in this way. Rather, your employer guarantees you a yearly income when you retire.
Example of a Final Salary Scheme
Suppose you have a final salary pension scheme. You earn £40,000 a year, and you have been working for the company for 25 years.
Your scheme also stipulates that your retirement income will be based on your salary at the time of your retirement, not your average salary over the course of your career.
What will your annual pension income be on retirement?
Years of pensionable service: 25 years
Salary prior to retirement: £40,000
Agreed accrual rate: 1/50th
Annual pension income: (25 years / 50) x £40,000 = £20,000 p.a.
Suppose, however, that your accrual rate was 1/80th. What would your annual retirement income be?
Annual pension income: (25 years / 80) x £40,000 = £12,500 p.a.
For this reason, it is important to review your final salary pension scheme as early as possible, to ensure you are getting the best deal in later life.
Final Salary Schemes: The Different Types
As explained above, final salary pension schemes can vary based on how they calculate your annual retirement income. I.e. some schemes will use a formula based on your salary prior to retirement, whilst others will use your average earnings over a recent period of your career.
These final salary pensions are a type of “defined benefit pension”. Some defined benefit pensions, however, will base your annual retirement income on your average salary throughout the course of your career. These are called ‘career average revalued earnings schemes’ (CARE schemes).
This difference can have quite a big impact on your yearly income when you retire.
For instance, suppose you work for a company for 25 years and you are on a CARE scheme. Your accrual rate is 1/50th, and you have had three different salaries over the course of your career:
£22,000 for the first 10 years
£31,000 for the next 10 years
£40,000 for the last 5 years
Your total earnings over the period will have been £730,000. Taking into account inflation (CPI capped at 3% per year), your revalued earnings will be £918,700, and your average revalued earnings over your career would therefore be £36,748 (£918,700 / 25). So what would your annual retirement income be, based on this figure?
Years of pensionable service: 25 years
Revalued Average career earnings: £36,748
Agreed accrual rate: 1/50th
Annual pension income: (25 years / 50) x £36,748 = £18,374 p.a.
In this particular example, therefore, the years of service and accrual rate were the same as the first example above of the final salary pension scheme.
However, under that scheme you would have ended up with £20,000 p.a., whilst under this CARE scheme example you would have ended up with £18,374 p.a. This is due to the difference in how salary earnings are factored into the formulas.
In another scenario, a CARE scheme could produce a more favourable retirement income than a final salary scheme.
Regardless of whether you are on a CARE scheme or final salary scheme, you should always check which of your allowances, overtime, bonuses and benefits are attributable to your pensionable earnings.
Can I Take a Lump Sum from my Final Salary Pension?
You might have seen that the UK government allows you to withdraw up to 25% of the value of your pension, tax-free, when you retire. For defined contribution pensions, where you have built up a pension pot over many years this will simply be 25% of the fund value.
With a final salary pension, however, taking a lump sum can be more complicated because you haven’t built up a retirement “pot” in the same way as a defined contribution scheme. This is because your employer promises you an annual income on retirement.
So, in the majority of final salary schemes, to take a lump sum under a final salary scheme, a calculation is made using a “commutation factor.” This means that you exchange a piece of your promised income for a lump sum.
For instance, if your scheme has a “commutation factor” of 10, this means you will get £10 in your lump sum for every £1 you forsake in your promised retirement income.
Scheme rules will normally limited the lump sum by either setting a limit on the value of the lumps sum, or a limit on the amount of pension you can give up. However, the HMRC rules place an over-riding maximum of 25% of the ‘value’ of your pension.
The value is calculated as 20 times the pre-commutation pension. E.g. if your initial pension was £20,000 per year, the value would be £400,000, and the maximum lumps sum would be £100,000 (scheme rules permitting).
What Happens if my Employer Goes Bust?
Businesses and other employers sometimes fail, which is a part of life. However, what does this mean for your final salary pension scheme if your employer becomes insolvent? Will you still get your promised retirement income?
The UK government set up the Pension Protection Fund (PPF) in 2005 with this in mind. Essentially, as of April 2018 this helps ensure that members of insolvent schemes can receive 90% of the promised pension up £39.006.18 (i.e. up to £35.105.56 per year) from the ir schemes normal retirement age. Members hos have already retired and have reached the schemes retirement age before the scheme’s insolvency will get 100% of the pension.
Pros of a Final Salary Pension
There are many pros and cons to having a final salary pension. The advantages include:
- Your scheme’s benefits are linked to your most recent salary, which in many cases tends to be when people are at their highest earnings.
- You are sheltered from investment and mortality risks. Your employer is managing your pension for you, so if there is a shortfall then most schemes will oblige them to make up the difference.
- Many pension plans will continue to pay out an income and benefits to your husband or wife after you die. Some schemes also extend benefits to your dependents.
- Final salary schemes include annual increases, which help protect the ‘real’ value of your income upon reaching retirement.
Cons of a Final Salary Pension
Some of the disadvantages of final salary pension schemes include the following:
- Death Benefits of final salary schemes will normally be limited to a pension for your spouse (and
occasionally dependent children).
- If your employer goes insolvent, then you are not necessarily guaranteed the full, promised yearly amount or same benefits. While most schemes will be eligible for protection by the PPF, some final salary schemes are not.
- Final salary schemes increase costs on employers, which puts pressure on other aspects of the business. For instance, company salaries might not be as generous or rise as quickly.
Final Salary Pension Benefits: A Summary of How They Work
You will normally be allowed to access the benefits contained in your final salary scheme when you reach the defined pension age.
Under certain final salary plans, you might be allowed to receive the benefits at other times if certain conditions are met. For instance:
- You are diagnosed with a terminal illness.
- Early or late retirement.
- You are forced to retire early due to ill health.
Your final salary pension should have a Board of Trustees responsible for it. If you are displeased with your scheme or feel the scheme hasn’t been following the rules, you can contact them. If you are unsatisfied with their answers then you can refer the matter to the Pensions Regulator or Pensions Ombudsman.
It is worth noting that the benefits of your final salary pension scheme might be subject to change, in light of new government legislation. However, outside of updates to the law, certain criteria have to be met prior to any change being made to your scheme (e.g. members have to be consulted first).
If you are unsure which benefits your final salary pensions scheme offers, then you should refer to the information booklet handed to you when you joined. If you no longer have it, contact your Pension Manager or Scheme Administrator.
Transferring A Final Salary Pension Scheme
People sometimes consider transferring their final salary pension, for instance to a personal pension or SIPP (Self Invested Personal Pension).
There are many reasons for this. Very common nowadays, is the objective to pass on after death, whatever monetary valuer remains within the pension, and leave a meaningful pension sum to younger generations in the family.
If you are thinking about transferring your final salary pension, then by law you will need to seek financial advice, Independent of the Trustees, if your pension is worth more than
Regardless, you should think very carefully prior to deciding on a final salary pension transfer. For most people the risk of being worse of in retirement will outweigh the potential benefits and you won’t have any right to get those benefits back if you later change your mind.
Watch our short video here to find out more about what’s involved in a final salary pension transfer…
Kevin O’Neill APFS
Founder & Chartered Financial Planner