If you have a final salary pension but you are uncertain about how they work, don’t worry. This article will tell you everything you need to know.
What is a final salary pension?
Also known as a ‘defined benefit’ pension or a ‘superannuation’ pension, this is a workplace pension that guarantees an annual income for the rest of your life on retirement.
This type of pension tends to be offered by public sector and government employers. Some larger private companies also offer them.
How do they work?
This type of pension is usually administered by a board of trustees. They are also responsible for the regular payments to retirees.
You are required to pay a proportion of your salary into the scheme during your working life. A typical contribution is around 4% – 6%.
The amount you receive is based on your years as a member of the scheme and your final salary at retirement.
The pension scheme stipulates an accrual rate. This is the proportion of your final salary that you will receive when retired.
For example, for a retiree with 20 years in a scheme, a final salary of £100,000 and an accrual rate of 1/80, the annual income would be 20 years multiplied by £100,000 multiplied by 1/80. This amounts to £25,000.
Are there many around?
Final salary pensions are declining, especially in the private sector. There are a number of reasons for this.
Running this type of scheme is very expensive. Companies have struggled to cope with periods of high inflation and low investment growth. In addition, life expectancy has increased so guaranteed pay-outs are greater.
As a result, many private companies have closed their defined benefit schemes to new members in favour of defined contribution schemes.
A defined contribution scheme involves payment into a savings scheme run by a pension provider. Contributions are made by you, your employer, and the government in the form of tax relief.
Can I transfer out of this type of pension?
You can transfer out of a final salary pension if it is supported by a central fund. This is known as a funded scheme.
If you are a member of an unfunded scheme you will not have the option to transfer out. Unfunded schemes include those for teachers, firefighters, the police and NHS workers. This type of scheme is paid for by the taxpayer, so there is no central fund.
The process of transferring out of a final salary pension is called a ‘defined benefit’ transfer. This involves leaving your existing scheme and transferring the lump sum to a defined contribution pension.
However, think carefully before doing this. While a lump sum sounds attractive, in order to get it you will have to give up your final salary pension benefits.
If you are in good health, a guaranteed income for life may amount to a greater sum in the long term. By transferring out, you could end up losing out.
If the value of the lump sum is more than £30,000, you are legally obliged to seek regulated financial advice.
What about withdrawing a lump sum?
Some final salary pensions allow you to take a cash lump sum. This is done via a process known as commutation. The amount you take will reduce the regular payment you receive at retirement.
The pension administrator will use what is known as a commutation factor to work out how much income you will need to sacrifice for a specific lump sum. You can withdraw a 25% cash lump sum tax free.
Working out what your pension will be after you have taken a specific lump sum is not a straightforward calculation. If you are considering taking a lump sum, it’s recommended that you seek regulated advice beforehand.
Take home
Before making any decisions, it’s best to seek advice from an independent financial advisor.
It’s also a good idea to do some research beforehand. If you are unsure about the basics, further information is available in our article about how pensions work.
You can also get information about final salary schemes from the Pensions Advisory Service.
