Answered by Stephen Moore
Transfers into final salary schemes are rare beasts
The opportunity to transfer into a final salary (defined benefit) pension scheme is an increasingly rare and valuable one. Final salary schemes deliver a guaranteed level of income in retirement that’s based on your number of years service and your salary when you leave the scheme or retire.
This means that any subsequent pay rises you might receive will automatically increase the value of your final pension, which adds to the appeal of this kind of transfer. The pension you receive will run from retirement until the day you die, the benefits will usually be linked to inflation and, upon death, there will typically be a reduced (50%) widow’s pension.
Based on earnings and service
Because it’s based on your years of service and salary, a transfer into a final salary scheme will most likely result in you being awarded ‘additional years’. This is because most schemes operate with an ‘accrual rate’ of either 1/80th or 1/60th of your salary for each year of service, subject to a scheme maximum.
The income you’ll get from a defined benefit pension is based on three factors:
- number of years you’ve been with that employer and contributing to the DB scheme
- your pensionable earnings (for final salary schemes, this is your salary at retirement; for career average schemes, this is your mean salary across your career)
- your pension scheme’s accrual rate (the proportion of your earnings you’ll receive for each year spent in the scheme, usually represented as a fraction, e.g. 1/80th).
The common calculations for working out how much your final salary pension is worth are:
Defined Benefit Scheme Calculation
Number of years in scheme
£50,000 final salary
Scheme accrual rate
30 years * £50,000 * 1/80th
The beauty of a final salary scheme is that the investment risk rests with your employer, not with you. This highlights how, if it’s a guaranteed level of income that’s most important to you in retirement, there’s nothing better than a good final salary scheme pension.
Such schemes also offer additional benefits such as death in service payments if you die before reaching pensionable age, a potentially full pension in the event of ill health early retirement and a reduced pension for early retirees from age 55.
Make sure you get expert financial advice
Even so, there are a number of pros and cons. Most notably, money purchase (defined contribution) pension schemes offer far greater flexibility when it comes to managing your pension benefits, including the opportunity to pass your unused pension wealth onto your beneficiaries.
In the case of a final salary scheme, once you and your spouse have died the pension ends, regardless of how much your ‘fund’ may have been worth or how long you may have drawn benefits.
This makes final salary pension benefits especially poor value for those in poor health who may not live long enough to get good value from their guaranteed income.
Final salary schemes also offer little flexibility when it comes to taking tax-free lump sums. Essentially, you have one opportunity to take (usually) up to 25% as a tax-free lump sum, the remainder of your ‘pot’ is then invested to deliver your income.
It’s also a relatively expensive option compared to taking a lump sum from a money purchase pension. Thanks to the ‘commutation factor’ that final salary schemes apply, any lump sum represents a sacrifice of future income.
Most schemes tend to have commutation factors of between 12 and 14 which means that for every £12 to £14 of lump sum you might take, you sacrifice £1 of annual income for the rest of your life. This is less than half the comparable annuity rate, despite the fact that annuity rates are currently locked at all-time lows.
However, the opportunity to accrue generous pension benefits without shouldering any of the investment risk is not to be missed – especially as you can always choose to transfer out of the scheme once more when retirement draws near.
This would enable you to take advantage of all the added benefits that come with income drawdown – such as the flexibility to take your benefits as and when you might need them or the ability to pass on your remaining pension wealth to your beneficiaries when the time comes. All this means that it makes sense to consult your pension adviser and agree on the best strategy before you make any lasting decisions.
Pension transfers and pensions freedom
Since the launch of the new pension freedoms in April 2015, savers with money purchase schemes have enjoyed almost unlimited freedom of access to their savings.
The new regime, based around what’s called ‘flexi-access drawdown‘, has increased the disparity between final salary and money purchase arrangements which now offer a range of tax saving, lump sum, investment and inheritance advantages over final salary schemes as well as the ability to access these savings from the age of 55.
All this makes it well worth spending out on some impartial professional advice. A good adviser will be able to research the benefits and the shortcomings of any such transfer, including whether your existing scheme carries any additional guarantees, the cost of any penalty charges that might accrue and the level of investment return you’ll need in order to enjoy the same sort of income in retirement.
Based on your individual circumstances and financial ambitions they can then advise you on whether the transfer makes good sense for you, now or in the future.
Frequently Asked Pensions Advice Questions
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