Is a final salary pension different to other pensions?
Yes, and it’s the word ‘guarantee’ that’s really worth having. There’s a promise to pay you a guaranteed amount of income at your retirement age, and that’s pretty much not the case with the overwhelming majority of other pensions.
You won’t have your own individual pension pot as you do with money purchase pensions which build up your savings based on what’s paid in and how well they grow. As a final salary scheme member, each year you and the other members build up benefits and in your annual statement you get to see how much income you have built up for that year and over previous years.
Final salary example
Schemes use an accrual rate (jargon alert) which is essentially a fraction given to you for every year you are a scheme member. So, for a scheme with 1/60 rate, each year you work you earn 1/60 of pension. If you work for the employer for 30 years then that’s 30/60.
This fraction is multiplied by your salary to decide your pension income e.g.
30/60 X £20,000 salary = £10,000 per year annual pension.
Final salary schemes are also overseen by scheme trustees who employ advisers to help with the administration, investments and all the legislative and regulatory requirements, and there’s a lot of those!
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Final salary pension principles
- You are generally required to pay into the scheme, and the government pays in too by giving you tax relief. Your employer must pay in to the scheme.
- There’s a single pension fund for you as a past or present member. Your employer has advisers called actuaries (basically very clever financial accountants) who advise them on the money they need to pay in to ensure your guaranteed pension can be paid.
- Although you can take out tax-free cash, you will also receive a pension income which is increased each year to give you some protection against inflation.
- There’s no investment risk for you as the scheme investments fund your pension and your employer must keep paying in to ensure there’s enough money to pay your income.
What happens if the scheme closes?
There can be a number of reasons why an employer might close a final salary scheme but in the majority of cases it’s down to cost. We’re all living longer and for your employer they have to provide a guaranteed income for all of your life and potentially that of your spouse/partner too. If economic times worsen then the funding also goes up and overall its that uncertainty that organisations find difficult to build into their plans.
If your employer’s business fails and the organisation stops trading then obviously the scheme will have to close. The good news is that there’s a lifeboat available, called the Pension Protection Fund which is designed to take over the pension from your employer and you would receive the majority of your future guaranteed pension.