What is a Final Salary pension?
A Final Salary pension scheme (also called a Defined Benefit pension) is a scheme that promises to pay out an income when you retire based on your time within the pension scheme and your salary when you leave the employer or retire.
Unlike personal pensions, the amount you’ll get at retirement is guaranteed, it doesn’t depend on the performance of stock markets. This guide explains how final salary schemes work and how you can work out how much income you could get in retirement.
If you've saved into a Final Salary pension scheme, your savings, along with the contributions of your employer and the tax relief you receive from the government, have been invested in the stock market over your working years.
But the income you ultimately receive from your pension is a guaranteed, pre-agreed amount. This is why they are called 'Defined Benefit' pensions.
Benefits of Final Salary pensions
Final Salary pensions offer important benefits to scheme members such as:-
- Guaranteed income
- Index Linking, ensuring that pensions being paid rise with inflation each year
- Lump sum death-in-service benefits to spouses
- Pensions to a spouse or dependants when a member dies
- A level of protection if the scheme can’t meet its liabilities
How do I work out my final salary pension income?
If you've saved into a final salary pension scheme during your career, it will provide you an income for your retirement based on three key factors:-
- The number of years you have paid into the scheme;
- Your final salary when you retire or leave the scheme;
- The accrual rate, i.e., 1/60th or 1/80th of your salary for each year of service
Let's look at how this works in practice: Your final salary when you retire is £30,000. You've worked at your company for 40 years. Your company uses an accrual rate of 1/60th. Your annual pension would be 40 x £30,000/60 = £20,000 initial pension income.
Tax Free Cash
In reality, most retirees don’t receive the full initial pension because they ‘commute’ part of their income for a tax-free lump sum.
The amount of income given up for a lump sum varies from scheme to scheme, working out whether the tax-free cash is a good deal is an important factor to consider. The calculation for the amount of tax-free cash available his known as a ‘commutation factor’. Here’s two worked examples:-
A scheme offers an initial pension of £20,000, or tax-free cash of £50,000 with a lower income of £15,000. The retiree has £10 of tax-free cash for each £1 of annual income given up, a commutation rate of 10.
A scheme offers an initial pension of £20,000, or tax-free cash of £100,000 with a lower income of £15,000. The retiree has £20 of tax-free cash for each £1 of annual income given up, a commutation rate of 20.
A higher commutation rate offers better value for the retiree.
Transferring out of a Final Salary scheme is unlikely to be in the best interests of most people
The value of pensions and the income they produce can fall as well as rise. You may get back less than you invested.
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