The Benefits of a Final Salary Pension
If you are among the legion of UK workers lucky enough to be a member of a final salary pension scheme, consider yourself fortunate. You are fortunate because the benefits of your pension far outweigh what most participants in defined contribution schemes will receive in retirement. Additionally, you are lucky to be a member now in light of the fact that large numbers of UK employers are closing the door on final salary schemes.
The final salary pension takes its name from the fact that retirement income is not directly tied to contributions or pension investments. Rather, it is a guaranteed amount of money based on either a percentage of the salary being earned at the time of retirement or an average salary calculation over a predetermined amount of time.
For example, say you participate in a scheme that guarantees you 80% of your salary average over the last ten years of service. Then assume your ten-year average worked out to £50,000. Your income in retirement would be £40,000 per year. Throw in your state pension payments and a few thousand pounds in savings, and you could retire without any drop in income. This is the primary reason final salary pension schemes are known as 'gold-plated' pensions.
How Final Salary Pensions Work
The typical final salary pension is established by an employer with oversight being handed off to a Board of Trustees. The board will appoint a pensions administrator who will handle the day-to-day administration of the scheme. Sometimes directors and administrators are also employees of the organisation; other times they are separate entities altogether.
These kinds of pensions are attractive because they provide a guaranteed income for life regardless of how long the pensioner lives. Annual payments are calculated according to several key factors:
- Years of Service – Also known as 'pensionable years', the final salary pension scheme considers how many years of service you have given to the company or organisation. The longer you work for them, the greater your payments are likely to be.
- Pensionable Earnings – depending on your position and the way you are paid, not all of your income may be taken into consideration when calculating your payments. Only money considered pensionable earnings is used in the calculation.
- Accrual Rate – The accrual rate is a proportional representation of that amount of pensionable earnings combined with years of service to determine payouts. For example, an accrual rate of 1/80 dictates that you will receive 1/80, or 0.0125% of your pensionable earnings for every year of pensionable service.
The accrual rate is truly the key to your benefits at retirement. Using the same example of £50,000 listed above, a 1/80 accrual rate for 30 years of pensionable service would work out to £18,750 annually. A 1/60 accrual rate would work out for £24,900 per year. The lower the accrual rate, the higher your income.
Additional Benefits of Final Salary Pensions
There are a number of other benefits that may apply to some final salary pension schemes. We say they ‘may’ apply because individual schemes are free to offer them or leave them off. One example would be additional contributions provided by the scheme itself. Not many final salary schemes offer this benefit, but some have done so in the past as a means of discouraging members from transferring out or as a way to help employers retain the best talent.
Another significant benefit, which is not optional, is the pension protection provided by the government Pension Protection Fund. This fund prevents pension members from suffering financial loss in the event their schemes wind up and insolvency. This is not as unusual as it sounds given the nature of the guaranteed benefits final salary pension schemes promise.
Final Salary Schemes and Pension Reform
There is little doubt that final salary pension schemes are excellent schemes offering retirement income and other benefits not afforded defined contribution pension members. However, the schemes, also known as defined-benefit schemes, have one major drawback: they are not eligible to participate in most of the reforms enacted in 2015. For example, a member of a defined contribution pension can cash out his/her pot as a single lump sum beginning at the age of 55. Final salary members cannot. Be aware that there is very good reason for this.
When government officials were drawing up plans for pension reform, they were well aware of the fact that final salary schemes are financially superior to their defined contribution counterparts. They also knew that final salary members could take a big financial hit and lose some of the extra benefits they had accrued by accessing their funds early. In order to prevent that, they excluded final salary schemes from pension reform.
Having said that, there is a workaround available. Members of final salary pension schemes can first transfer out of their schemes and into a defined contribution pension (i.e. a stakeholder pension, SIPP, or new occupational pension offered by an employer) and then access the cash according to the new rules. Nevertheless, there are definite drawbacks to doing so:
- Transfer Value – Anyone wishing to transfer out of a final salary scheme would first request a transfer value from the administrator. This value is essentially the amount the scheme will offer you should you decide to transfer out. Rarely is this amount anywhere close to 100% of the value of your final salary guarantee.
- Exit Charges – Final salary pension schemes almost always have associated charges for an early exit as a means of dissuading members from transferring out. These charges tend to be punitive for that reason. It could cost you a lot of money to get out just so you can access pension freedom options.
- Additional Benefits – Members can pretty much guarantee that any additional benefits offered by the pension scheme will be lost upon transferring out. Those additional benefits are designed to keep you in; they will not remain intact if you transfer out.
- Lost Guaranteed Income – The biggest drawback of transferring out of a final salary scheme is the loss of guaranteed retirement income. Once you leave your scheme, your retirement income will be based solely on how much cash you put toward your new defined contribution scheme and how well that scheme performs in the investment arena.
It should be clear from this list of drawbacks that transferring out of a final salary pension scheme is rarely a good idea, if at all. It may be right for some who need emergency cash or who might be very good at investing and able to make even more money by transferring out. Nonetheless, for the average day-to-day worker, leaving a final salary scheme intact is the best way to go.
In closing, consider yourself very fortunate if you participate in a final salary pension scheme. You are among a group of workers in the best possible position to retire with no worries of income. Now be sure to make the most of your financial situation by sitting down with a certified financial advisor to learn how you might be able to make improvements. The world is constantly changing; your current plan might need to be adjusted to take into account future changes.
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