What is a final salary pension?
A defined benefit pension scheme – sometimes called a final salary pension scheme – is one that promises to pay out an income based on how much you earn when you retire. Unlike defined contribution (DC) pensions, the amount you’ll get at retirement is guaranteed, and it will be paid directly to you – you won't have to use your pension pot to decide your next move.
What are the different types of final salary pension?
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.
There are two types of defined benefit pension.
- Final salary schemes, which are based on how much you're paid when you finally retire
- Career average schemes, which are based on an average of your salary across your career.
Both types of pension provide valuable benefits, the biggest of which is something called 'index linking. This means that your pension income is guaranteed to rise each year so it can keep up with rising prices in the future. This protection is usually capped at 2.5% a year, although, in some cases, it's linked to the Retail Prices Index measure of inflation.
Other benefits of final salary pensions
Other benefits of final salary pension schemes include:
- death-in-service payments to spouses, partners or dependants if you die before reaching pensionable age
- some schemes offer full pension if you have to retire early through ill-health
- reduced pension if you retire early, although this can’t be done before the age of 55.
Private sector vs public sector final salary pensions
Defined benefit pensions have historically been provided by both private companies and public sector organisations. Final salary pensions are in decline, but millions of people still hold them. If you hold a private-sector DB pension, you have the right to request a transfer, as do members of so-called ‘funded’ public sector schemes. In a funded plan, contributions from the employer and employee are invested in a fund towards meeting the benefits. Some public sector schemes, such as those for teachers, NHS workers, the armed forces, the civil service, police, and fire service, aren’t linked to specific pension funds (they’re paid out of general taxation). These are known as ‘unfunded’ DB pensions.
Can I cash in or transfer my final salary pension?
Transferring out of a final salary pension is unlikely to be in the best interests of most people.
You will be giving up all of the guarantees that a final salary pension offers you if you transfer out.
The value of pensions and the income they produce can fall as well as rise. So, you may get back less than you invested.
What this guide does seek to do however is simply to help you in the early stages of considering a Final Salary Pension (Defined Benefit) to a Personal Pension (Defined Contribution) transfer by familiarising you with some of the key issues that you will need to take into consideration. The guide seeks neither to encourage nor to discourage such transfers, but to set out in a balanced way the pros and cons of retaining your Final Salary pension rights as compared with taking a transfer.
This guide helps pension scheme members to understand the value of what they already have as well as the potential benefits of transferring before having a more in-depth conversation with their Pension Transfer Specialist.
Former pensions minister and Director of Policy at Royal London, Steve Webb, said: "Large numbers of people are still transferring out of traditional salary-related pensions, but whether this is a good idea or not depends crucially on your individual circumstances.
For most people, a guaranteed salary-related pension that lasts as long as you do and is unaffected by the ups and downs of markets will be the best answer."
Five Reasons to Leave
1. Flexibility - Instead of taking a set pension on a set date, you have much more choice how and when you take your pension. Many people are choosing to ‘front load' their pensions so that they have more money when they are more fit and able to travel, or to act as a bridge until their state pension or other pensions become payable.
2. Tax-free cash - Many Final Salary pension schemes offer a pretty poor deal if you want to convert part of your DB pension into a tax-free lump sum. Although the tax-free cash is in theory 25% of the value of the pension, you often lose more than 25% of your annual pension if you go for tax-free cash. In a Personal Pension (DC) you get exactly 25% of the pot as tax-free cash.
3. Inheritance - Generous tax rules mean that if you leave behind money in a Personal pension pot it up to 100% can be passed on with a favourable tax treatment, especially if you die before the age of 75. In a Final Salary pension, while there may be a regular pension for a widow or widower, there is unlikely to be a lump sum inheritance to children etc.
4. Health - Those who live the longest get the most out of a Final Salary pension, but those who expect to have a shorter life expectancy might do better to transfer if this means there is a balance left in their pension fund when they die which can be passed on. (Note that HMRC may challenge this for those who die within two years of a transfer.)
5. Employer solvency - While most pensions will be paid in full, every year some sponsoring employers go bankrupt. If the Final Salary pension scheme goes into the PPF, you could lose 10% if you are under pension age and may get lower annual increases, underfunded Schemes are likely to reduce Transfers to reflect the funding position; reducing the potential benefits of a transfer but if you have transferred out, you are not affected. But Pensions in payment are protected 100%.
Five Good Reasons to Stay
1. Certainty - With a Final Salary pension, you get a regular payment that lasts as long as you do but with a Personal Pension pot, you have to face ‘longevity risk' - not knowing how long you will live.
2. Inflation - A Final Salary pension has a measure of built-in protection against inflation, but with a Personal Pension pot you have to manage this risk yourself, which can be expensive.
3. Investment risk - With a Personal Pension you have to handle the ups and downs of the stock market and other investments. You also need to be careful not to draw too much of your fund to
ensure that you don’t run out of money in retirement. Whereas with a Final Salary scheme you don't need to worry - it's the scheme's problem.
4. Provision for survivors - By law, Final Salary pensions have to offer a minimum level of pensions for widows/widowers etc., whereas if you use a Personal pension pot to buy an annuity, it dies with you unless you pay extra for a ‘joint life' policy.
5. Tax – Final Salary pensions are treated relatively favourably from the point of view of pension tax relief. Those with larger pensions could be under the lifetime allowance limit inside a Final Salary scheme but the same benefit could be above the limit if transferred into a Personal Pension arrangement.
It's in the best interests of most people to stay in their DB pension. Worried about your pension? | Pension Protection Fund (ppf.co.uk).
