What is a Final Salary / Defined Benefit Pension?
One of the questions we often get asked here at Pension Partner is ‘what exactly is a final salary scheme?’ This article aims to give readers a brief understanding of what these types of pensions are, and how to know if you may have one.
To begin with, it is important to note that there are a number of different pension types. Most pensions will fall under the category of defined benefit, defined contribution or state/government pensions with many variations of each. Should you be unsure as to what type of pension you may have, browse our website to learn more or get in contact with our friendly team.
What is a final salary / defined benefit pension?
A defined benefit pension is a type of occupational pension scheme and it is rare to find employers that still offer membership to new employees. In short, these pensions will usually be salary related and provide you with a retirement income which has been based on your salary and length of service.
Final salary schemes will provide you with a pension until your death, after which your spouse will receive (in most cases) a reduced pension for the remainder of their life. Children can in some circumstances receive benefits from these pensions upon a member dying, but this is uncommon.
Your benefits accrued within a final salary scheme are also 'index-linked' - meaning they will continue to rise in line with inflation. This can be based on retail price index, consumer price index and in some cases a fixed revaluation rate offered by your scheme, or perhaps a mixture of all three for various periods of service which can be confusing. As pensions are an asset that cannot be drawn from until we reach 55 years old, it is very important that they experience some kind of growth in order to avoid a loss of purchasing power due to inflation over a long period of time. It is therefore particularly important to understand the growth that you can expect from such schemes and ultimately what you expect to receive from them in retirement.
How is my defined benefit pension calculated?
Here's a quick example - remember, these figures are for demonstration purposes only - every company will use different numbers and accrual rates, in addition to numerous other factors:
John leaves Company X, where he was earning £40,000 per annum in his final year of service.
He worked at Company X for 15 years
Company X uses an accrual rate of 1/60th of a member’s final salary for each year of service.
John's annual pension would be £10,000 (15 (years) x 1/60th (accrual) x £40,000 (final salary).
Once again this is a rough guide, and you are advised to ask your financial adviser or scheme administrator for this information.
Many scheme members also take advantage of their opportunity to receive an annual CETV completely free of charge - be sure to read our article: What is a CETV to find out more.
A CETV (cash equivalent transfer value) will provide members with a cash equivalent sum that they can transfer into a pension of their choosing and give up the annual pension accrued within their defined benefit pensions.
Please note that any CETV offered by a defined benefit pension should be carefully considered and advised upon by a fully qualified and authorised financial adviser.
It is now a requirement of the FCA for all final salary members whose CETV’s are valued at above £30,000.00 to obtain financial advice prior to transferring.
Another form of defined benefit pension are CARE schemes, which is short for
'Career Average Revalued Earnings' - this is typically based on your average earnings throughout your career and are similar to final salary pension schemes in numerous aspects.
What would happen to my final salary pension if the company were to collapse?
This is a very relevant question that many members have. In short, the employer and scheme would be assessed by the UK's "pension lifeboat" scheme, the Pension Protection Fund - known as the PPF.
The PPF would assess whether they could take the scheme on board with a view to providing a reduced pension pay out for members. Members of defined benefit pensions have been known to transfer out of their schemes upon receiving news that they will be assessed by the PPF, it is strongly advised that members in such circumstances obtain appropriate and thorough advice before making such decisions.
If you are unsure which type of pension you have, or believe you may have a final salary pension that you have lost track of, Get in touch with our friendly Pension Investigators and we’ll find out all the information you need to ensure you’re in the know.