Defined benefit: Final salary schemes
Final salary schemes are a type of defined benefit pension scheme that are offered by employers. The benefits you receive at retirement are based on your earnings and your length of membership in the scheme.
How final salary schemes work
Many final salary schemes have either been closed to new members or to all members over recent years, although they are still offered by some, mainly larger, employers.
A final salary pension scheme is typically run, on behalf of the employer by the Board of Trustees, who is responsible for all aspects of the scheme. This includes paying benefits to retired members. Daily management of the scheme is typically done by the Scheme Administrator, who reports to the Board of Trustees.
A final salary scheme normally offers you an income in retirement based on a proportion of your ‘final salary’, although other factors can be taken into account. It’s important to note that ‘final salary’ doesn’t necessarily mean the actual salary that you're earning at the time you retire and draw your benefits from the scheme.
Example: What is meant by ‘salary’ or ‘earnings’?
The pension scheme’s rules will define what is meant by your ‘salary’ or ‘earnings’ and how the calculation of ‘final salary’ or ‘final earnings’ is made.
For example, some schemes don't count additional earnings, such as overtime, commission, bonuses or the value of benefits in kind (other benefits that are not paid as cash to the member).
The scheme may also only count a proportion of your wages or salary. The amount of earnings that are used to calculate retirement benefits is often called ‘pensionable earnings’.
If you’re a member of a final salary scheme, your pensionable earnings are recalculated each year, to take account of changes in pay. When you decide to retire and draw pension benefits from the scheme, your ‘final pensionable earnings’ are calculated, according to the scheme rules. These may be pensionable earnings in the final year before retirement, or may be an average of pensionable earnings over a specificed prior to retirement.
As a member, you will build up a fraction (the accrual rate) of your final pensionable earnings for each year of membership of the scheme. Typically, this fraction may be 1/60th or 1/80th of final pensionable earnings for each year of scheme membership, although other fractions may be used. You can check this in your scheme’s rules.
John is about to retire. He has been a member of his employer’s final salary pension scheme for 40 years. The scheme’s accrual rate for building up pension is 1/60th for each year of membership of the scheme. John’s final pensionable earnings are £30,000 per year.
This means that John can receive a pension of £20,000 per year (40/60 x £30,000) from the scheme.
As well as providing you with a pension income at retirement, some schemes also provide a tax-free cash lump sum. For example, some schemes with an accrual rate for pension of 1/80th of final pensionable earnings for each year of scheme membership, may also provide a tax-free cash sum of 3/80ths of final pensionable earnings for each year of scheme membership.
Other schemes may offer you the option of taking a tax-free cash lump sum on retirement in return for receiving a reduced pension. They will specify the maximum amount of tax-free cash lump sum that can be taken and the amount of tax-free cash lump sum that will be paid for each £1 per year of pension that is given up. This is often called the cash commutation factor.
John, in Example 1, has been offered the option of taking a maximum tax-free cash lump sum of £45,000 and a reduced pension. The cash commutation factor is £12 of tax-free cash for each £1 of pension given up.
If John decides to take the maximum tax-free cash lump sum of £45,000, his pension is reduced by £3,750 per year (£45,000/£12) to £16,250 per year.
Pensions in payment are taxed as income, but you do not pay National Insurance contributions on pensions income.
Pensions that are being paid to you after retirement may be increased each year to offset the effects of inflation. The amount of the annual increase may be specified in the scheme rules, or may be decided by the Board of Trustees.
Ill health retirement
Should you fall seriously ill, and be unable to work before you retire, you may be able to draw your pension benefits early, although the amount received may be less than if you carry on working until you retire. To find out more about ill health retirment please click here.
If you have dependants, they may also be able to receive a pension should you die, either before and/or after your retirement date. Again, you should check the scheme rules. If you'd like to read more about dependants benefits, please click here.
If you've left your final salary scheme
If you were a member of an employer’s final salary scheme, but have now left, you may have kept the benefits under the scheme. When you left the scheme, the Scheme Administrator should have provided you with a pension statement showing the amount of pension benefits that you have built up in the scheme. These amounts are usually revalued each year to offset the effects of inflation.
Transferring from your final salary scheme to a new pension scheme
If you have joined a new pension scheme, you may want to consider transferring the value of any old pensions to the new scheme. Please talk to us if you are interested in this. There are many factors that should be taken into account before deciding to transfer a final salary pension, especially as some of the guarantees available can be very valuable.
How can I find out what benefits my final salary scheme offers?
You should normally have been given a booklet when you joined the scheme. This booklet would give you details of the benefits. If you no longer have the booklet, contact the Scheme Administrator and ask for details.
I have lost the contact details for the Scheme Administrator, what can I do?
If you have lost track of your pension details don't worry. There are lots of things you can do to locate your 'lost pension'. Click here for more information.
Where can I find out more?
If you need more information, please contact us. A pension specialist from our team will be happy to help with whatever pensions-related question you have. Our help is always free.