What is a Final Salary Pension?
Final Salary Pensions, also known as Defined Benefit (DB) pensions, are a special type of workplace pension that is now in limited supply.
Most pensions are invested into funds (which can go up and down over time). With common pensions, your income depends on the growth of those funds. So, if your pension drops in value, you may have to reduce the amount you take each year. However, with Final Salary pensions, they provide you with a guaranteed income for life. Actuaries are responsible for calculating the amount of benefit you receive under these types of schemes.
How is Final Salary/Defined Benefit calculated?
The ‘Defined Benefit’ element is the pension income you will receive.
This figure can be shaped by:
- Size of Salary when you leave employment
- How long you have worked there for
- The ‘accrual rate’ of the pension scheme
To put it in simple maths terms:
Say your DB pension scheme’s accrual rate was 1/80th.
You would be entitled to a pension to 1/80th of your final salary for every year of service.
As an example, if you have 25 years of pensionable service and leave employment on a £60,000 salary, your pension would be 1/80th of £60,000 multiplied by 25.
1/80th of £60,000 = £750
£750 x 25 = £18,750
This income is guaranteed until death with most schemes offering a spousal benefit.
When can I access my pension?
The minimum age you can take money from most pensions is age 55 (soon to be pushed back to 57!!). Although, it is a little bit more complicated if you have a final salary pension.
For this type of plan, the scheme will set a ‘normal retirement age’. This is the age at which you can start taking the full benefits. The age can depend on the type of scheme you’re in or when you joined. But it’s pretty easy to find out from the scheme what this age is!
Can it go down in value?
Generally, the income doesn’t. In fact, it usually increases (in line with inflation rates).
However, the Cash Equivalent Transfer Value (CETV) can.
A CETV is the ‘lump sum value’ that your pension provider may offer you in exchange for giving up your guaranteed income. This amount can then be transferred to a personal pension to be invested.
What about Tax Free cash?
Many pension schemes allow you to take 25% of your pot free of tax – including DB pensions!
But when it comes to a DB scheme, withdrawing cash lump sums is known as commutation.
Figuring out how much you can take is based on a commutation factor. Even when trying to figure out the 25% tax free cash, it’s not a simple calculation.
Can a frozen DB pension still grow?
If you have left a certain workplace where you had a DB pension scheme, it will be classed as ‘frozen’.
As you no longer work there, the money you get from the pension will remain the same based on the accrual rate, length of pensionable service and your salary when your employment with the company ceased.
Is it worth transferring a Final Salary pension?
It CAN be worth transferring a DB pension, but it’s definitely not for everyone.
The main pros and cons are as follows:
|Guaranteed Income for Life||Lack of Flexibility|
|Inflation Proofed- Will not decrease||No nominations available (on death)|
|Not subject to Volatility||Complex Calculations|
Should I transfer?
No good adviser could tell you whether transferring would be the best option for you without meeting and delving deeper into what your personal/financial objectives are, weighing up the pros and cons relevant to you personally and doing all the calculations (etc.) ‘behind the scenes’.
Final Salary schemes are very complex, and because of the risks surrounding them, it is important that you seek advice from someone with the knowledge and experience to ensure you choose the best option for you. Especially because the decision is not reversible.
In fact, because this advice is so crucial, the FCA have made it mandatory to consumers to seek advice before transferring a DB pension if it is worth more than £30,000. An adviser must sign off the transfer before the scheme will release any funds. Pensions below this amount can be transferred without advice.
If you’d like to know more about Final Salary Pensions, we are hosting a FREE Webinar and Q&A on Monday 23rd November 2020. Please follow the link below for more details.