Your guide to final salary pensions
What are final salary pensions?
Final salary, or defined benefit, pensions pay a guaranteed income for life when you retire. This is based on a percentage of your final salary multiplied by the number of years you have been in the scheme. This ‘accrual rate’ is usually 1/60th, 1/80th or 1/100th of the final salary amount.
By contrast, with defined contribution (DC) schemes your final income will depend on the total value of the contributions made to it plus investment performance. Additionally savers in these schemes will have to work out the best way to turn that pot into an income.
Outside of the public sector, final salary or defined benefit (DB) schemes are becoming increasingly rare as employers move to the cheaper defined contribution (DC) schemes.
How much will your pension pay out?
Just how much money your pension will pay will depend on your salary, the accrual rate on the scheme and the number of years you worked. If you aren’t sure what your accrual rate is, ask your employer for more information. Figures produced by JLT Employee Benefits show the income that can be expected for those on the average wage as well as those in the top 10% of earners.
Hugh Nolan, chief actuary at JLT Employee Benefits, says there is no ‘magic trick’ to DB pension schemes and that the same amount of income could be replicated by saving the same monthly amount into a DC scheme.
When will your payments start?
The point at which you are eligible to retire and start receiving your pension will usually be set when you join the scheme, but it may not be set in stone, giving you the flexibility to work past retirement age or retire early if you wish.
In these cases Helen Forrest, an expert at the National Association of Pension Funds says your income will be recalculated accordingly: “If your retirement age is 65 and you want to retire at 60 the income will be actuarially reduced to make up for taking it five years early.”
Taking out cash tax-free
You are entitled to take 25% of your pension as a tax-free lump sum. However the means of calculating the exact amount is complex because you don’t have a finite pot like savers in DC schemes. To calculate how much money you can take schemes use a ‘commutation calculation’.
By taking out your tax-free lump sum you will need to give up some of the income that will be paid during your retirement. This is determined by the ‘commutation factor’ of your scheme.
A commutation factor of 10, for example, would give you a £10 lump sum for every £1 of income you give up. Commutation factors differ with each scheme, but you can request the calculations from your scheme. The higher the factor, the more money you’ll get. Before taking your cash, make sure you can survive on the reduced income.
Another reason DB schemes are so envied is that the pension income will increase over time either at a fixed rate or in line with inflation.
Hugh Nolan, chief actuary at JLT Employee Benefits says: “Schemes that were set up way back when inflation was 10% could have a fixed rate of 5%. This is higher than inflation is now and so we see people retiring whose pension is increasing... and they have more money in real terms than when they first retired.”
Although someone who dies early on in their retirement may not benefit from this aspect of their pension, any surviving spouse will get a rising income as DB schemes typically offer spousal benefits.
“DB pensions also come with dependants’ protection,” says Forrest. “If you die in service or in retirement, then your spouse is protected and given a proportion of the pension. Dependents such as children under the age of 23, who would also get a proportion.”
Usually a pay out to a widow will be half the original amount, although this is not the case with every single scheme.
Unmarried couples will miss out though, as partners cannot be nominated as a beneficiary.
Can you access the pension freedoms?
Currently the new pension freedoms are only available to members of DC schemes. So despite final salary schemes being described as ‘gold plated’ some members are now starting to covet DC schemes because they can spend their savings as they wish.
However, it is possible to transfer from final salary to DC (unless you are a member of a public sector unfunded scheme for example NHS or Teachers). In order to protect retirees who may not realise the benefits of a guaranteed lifetime income, the government has requested that a person whose total DB pot is worth more than £30,000 get their transfer request signed off by an independent financial adviser; those whose pension is worth less than this sum can transfer automatically.
Note that the £30,000 threshold does not apply to the amount of income that is paid out but the ‘transfer value’ of the pot. In other words, the total amount that the DB scheme expects to pay out over a person’s lifetime. A pot with a transfer value of £30,000 would equate to an income of between £1,000 and £1,500 a year.
Schemes have a legal duty to honour transfer requests made more than a year before the retirement date set by the scheme but if the request is within this time period then this does not apply.
“This is because for a scheme to pay out on, say someone’s 65th birthday, the scheme will have to liquidate assets to pay the pension and that will have already started,” says Forrest.
There are scenarios, however, when a transfer makes sense. If a person is single, they may want to cash in, as they will be paying for spousal benefits they do not need, and those in ill health, who will not live long enough to benefit from the lifetime income, could be better off transferring.
The cash equivalent transfer values (CETV) is an assessment of the total accumulated cash value of a pension you will be able to take out of your existing pension and move into a new one should you change employers or decide you want to move to a more flexible scheme with greater benefits and lower administration costs. The transfer value will depend on the trustees of the pension fund assessing your contributions and investment growth to determine the transfer value, which may have to be certified by the scheme’s actuary.
Tax-free lump sum
An inelegant phrase that is nonetheless accurate in what it describes: a one-off payment to a beneficiary that is free of any form of taxation. Usually received when using a pension fund to purchase an annuity, as 25% of the overall fund can be taken as a tax-free lump sum.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).