How does a final salary pension work?

What is a final salary pension?

When it comes to our retirement, making sure that every penny of our pensions count is critical. Final salary pensions guarantee you an annual income for the rest of your life and are frequently offered to those working in the public sector i.e. the health, education and government services.

We are going to explore how a final salary pension works so that you have a full understanding of the ins and outs of a final salary pension, which is also known as a defined benefit scheme (DB pension).

A final salary pension – a type of defined benefit pension – is a pension that is paid to you based on your final salary when you retire.

For those who are granted a final salary pension, this promises to provide a guaranteed income for the remainder of the retiree’s life.

Sometimes people sell their final salary pension, which can leave people vulnerable to pension mis-selling. For more information on mis-sold final salary pensions, visit here.

How are final salary pensions calculated?

With a final salary pension, you will be paid retirement income according to your final salary and years of service.

Specifically, there are three considerations taken into account when a final salary pension is calculated:

• Length of service – how many years the employee has worked for the employer and contributed to the pension scheme.
• Salary at retirement – what the employee’s salary is at the time of retirement.
• Accrual rate – the proportion of earnings you get for every year spent on the scheme, often represented as a fraction e.g. 1/60th.

Standard final salary pension calculations

No. years in scheme x final salary x accrual rate = final salary pension income

No. years in scheme – 30
Final Salary – £50,000
Accrual Rate – 1/80th
Final Salary Pension Income – £18,750 per annum

How does a final salary pension work?

Upon joining a final pension salary scheme, your employer will contribute to your pension fund on your behalf. The scheme then determines your expected retirement date and when you are to begin receiving a retirement income.

Defined pension benefit schemes are often index-linked and this means that your retirement income will increase per year to accommodate rising living costs.

The benefits of a final salary pension

Here are some of the benefits people get with a final salary pension:

Guaranteed payouts for life

Not only can DB pensions fund a stable retirement income, but also an income that is guaranteed for life; instead of a pension that sits in a pot accumulating over time.

Accommodating of rising living standards (index-linking)

As DB pensions are often index-linked, your pension is guaranteed to increase per year to keep up with rising prices of living. This means that you are more likely to have a secure and financially stable income.

Accommodating of unforeseen/changes in circumstances

Death-in-service payments

Should a person on a final salary scheme die before reaching their retirement age, the employee’s spouses, partners or dependents may receive death-in-service payments to support them.

Early retirement due to ill health

If a person on a DB scheme is forced to retire early due to ill health, they may receive their full pension.

Reduced pension

Those who choose to retire early can often receive a reduced pension, although this is not allowed if the participant is under the age of 55 years.

The disadvantages of a final salary pension

As well as generous benefits, there are also a number of drawbacks attached to a final salary pension scheme:

Not flexible

Unlike a defined contribution pension (DC pension) that builds up over time and is supposed to last you for the remainder of your retired life once you access it, a DB pension is not flexible in this way.

For instance, with a DB pension, you are unable to change the amount of retirement income you receive from it or take out larger amounts (with the exception of the tax-free lump sum that is offered in some cases).

Cannot be inherited

A DB pension cannot be inherited by a retiree’s beneficiaries and although there are death-by-service payments available, most of the pension scheme’s benefits will be void and cannot be passed down to children.

Risk of losing pension

Although this is not a huge risk, there is still a risk that a DB pension scheme could be taken away.

This is due to the fact that DB pensions are dependent on being adequately funded by the employer and should any issues arise financially on their end or otherwise, this can put your pension in jeopardy.

In cases where a DB pension is unable to be funded by the employer, it will be paid using the Pension Protection Fund (PPF); a service that protects individuals with a final salary pension in the event of their employer going into insolvency. However, there is still only so much that they can do.

Transferring your final salary pension

What is a Defined Benefit pension transfer?

There is an option for employees on a DB scheme to transfer their DB pension in exchange for a fixed pension such as the defined contribution pension (DC pension).

When it comes to a final salary pension transfer, a pension provider may offer money in exchange for your pension and the sum that they provide is known as a ‘Cash Equivalent Transfer Value’ (CETV).

A CETV can be invested into a pension pot and withdrawn from the age of 55.

How does a pension transfer work?

If you make the decision to transfer your final salary pension, you will receive any benefits that have built up in the form of a cash sum (CETV) and you then have to invest this.

Investment options include:

• personal pension
• another employer pension scheme
• self-invested personal pension (SIPPs)

The advantages of transferring your final salary pension

• You can receive your pension at an earlier age.
• You can vary your income.
• Any unspent retirement income can be inherited by beneficiaries without the burden of inheritance tax.
• Your pension is not at risk if your employer’s pension goes into insolvency.

The risks of transferring your final salary pension

• You are giving up a guaranteed annual income for a sum of money that could run out down the line.
• If the stock market performs poorly, this can pose a risk to your pension pot.
• There may be additional costs to pay during the transfer.
• You take full responsibility for your pension.

Making a decision

Ultimately, the decision to transfer a defined benefit pension is yours upon weighing up the pros and cons. You must always seek advice from an authorised financial advisor before making any big decisions in regards to your pension fund.

There are many risks associated with transferring from a DB pension scheme to a DC scheme and what might be suitable for someone else may not necessarily be the right decision for you.

What is a mis-sold final salary pension?

A lot of individuals, particularly employees in the public sector, have been misled and advised to transfer their pensions into a ‘money purchase scheme’.

If you are wrongly advised, persuaded or encouraged to invest your pension into an unsuitable or risky venture, you may be entitled to mis-sold pension compensation.

Making a mis-sold final salary pension claim

At Spencer Churchill Claims Advice, our specialist team can help with final salary pension transfer claims and many other mis-sold pension claims with no upfront costs.

If you need to make a claim, contact us today to speak with a case handler.