A final salary pension is a type of defined benefit pension. Here the benefit you receive in your later years is defined from the outset of retirement; you’ll also typically receive inflationary increases on the amount you receive throughout retirement.
The two terms — final salary pensions and defined benefit pensions — are sometimes used interchangeably because final salary pensions are the best-known type of defined benefit pension. However, they aren’t in fact interchangeable. A final salary pension is a type of defined benefit pension scheme, of which there are two main types:
Final salary pensions are seen as the ‘gold standard’ of retirement savings because they offer a guaranteed income for the rest of your life, index-linked to maintain pace with inflation.
They also usually offer a survivor’s pension for spouse should you pre-decease them. This all happens without any investment risk to you at all. This makes these pensions incredibly valuable.
The income you’ll get from a defined benefit pension is based on these factors:
How to Calculate a Defined Benefit Pension
Number of years in scheme
£50,000 final salary
Scheme accrual rate
30 years * £50,000 * 1/80th
Under normal circumstances, you usually get access to your defined benefit pension at the scheme’s normal retirement age (NRA). This is typically set at 60 or 65 and is an age where your employer stops paying into your pension and starts to pay out benefits.
You may be able to defer receiving your final salary pension until a later age and potentially see an increase in your yearly income — you’d need to check with your scheme’s administrators for their rules on this.
You can technically ask for access to your pension earlier, from age 55, if the scheme permits this. However, this may reduce the amount you’re entitled to in yearly income by what’s known as the early retirement factor.
However, if you’ve been diagnosed as seriously / terminally ill, the scheme may waive this rule reducing your pension for retiring early. This will be dependent on your individual circumstances.
A final salary pension transfer involves you giving up your right to a pension and all of its guarantees in exchange for a lump sum invested in a defined contribution or money purchase pension. The lump sum you receive is known as the scheme’s cash equivalent transfer value (CETV).
By transferring, you give up a guaranteed income for life and any other benefits you would have been entitled to under the scheme.
If you agree to a final salary transfer then you take on board the risk that what happens with the above and any other factors do not match the assumptions made. That can work against you in that you find the cost of securing an income is higher than expected or the fund performs poorly, meaning you aren’t able to match the benefits the defined benefit scheme would have provided.
As a result, you could find yourself worse off in retirement if you leave your final salary scheme than if you’d remained a member.
Of course, this could work for you in that the cost of securing an income is lower than assumed and / or the value of the fund are higher than expected, potentially leaving you better off than you would have been in the scheme.
Following the April 2015 pension freedoms, you’ll have all the same benefits from your new money purchase pension as if you’d had this type of pension all along.
It’s impossible to predict what will actually happen with a money purchase pension fund which means you could end up worse off in retirement than if you’d stayed in the scheme.
Head of Financial Planning at Drewberry
High transfer values reflect the high cost of providing a final salary pension. Access to the pension freedoms may seem tempting, but a final salary pension transfer is only suitable for a minority of members.
If you have a private sector defined benefit pension, then you will most likely be able to transfer out. This is unless it’s been moved to the Pension Protection Fund due to funding problems or if your employer has gone bust.
Public sector workers are often members of final salary schemes. These include teachers, NHS workers, the army, the police force and firefighters.
However, these are what’s known as ‘unfunded’ schemes. This means the pensions they provide are a promise from the government rather than being backed by an underlying investment fund. As such, it’s not possible to leave.
The one notable exception to this is the local government pension scheme, which is funded. Transfers are therefore usually possible from this plan, although note that the same rule of thumb applies here. While a transfer is possible, it’s likely only a viable solution for a minority of scheme members.
If you want to cash in your final salary pension and give up all of the benefits of being in the scheme, then your first port of call should be a visit to a regulated adviser, such as one of the team at Drewberry. This is a mandatory legal requirement if your pension is worth more than £30,000.
Cashing in your final salary pension involves complicated analysis of the pros and cons of doing so to check whether it’s the right option for you. For most people, it won’t be the right decision and they’ll be better off staying in the scheme.
Should it appear favourable that you transfer, however, an adviser can then write to your scheme and request a cash equivalent transfer value on your behalf. After requesting one, it’s valid for a 3 month window.
During this time period, your adviser will have to carry out a lot of detailed analytical work to ensure the transfer happens smoothly.
Yes, you can transfer your final salary pension to a SIPP. In fact, a SIPP is one of three investment vehicles you must transfer your final salary pension to if you do go ahead, with the other two being:
Important! Not all employer pension schemes, personal pensions or SIPPs accept transfers in, so be sure to check yours will before you try and transfer your pension into one.
Your final salary pension is hugely valuable. It’s a promise to pay you a guaranteed retirement income for the rest of your life, index-linked so it won’t ever be eroded by inflation, and typically then a spouse’s pension if you predecease your husband / wife / civil partner. Giving this up is risky because you lose all of the guarantees that come with having a final salary scheme.
The alternative to taking this secure income is to consider a final salary pension transfer.
Here, the value of your final salary scheme is defined by the cash equivalent transfer value or CETV. This is the sum of money you’ll receive for leaving the scheme and giving up the rights and guarantees you previously enjoyed as a member. It will be invested in another form of pension known as a defined contribution or money purchase scheme.
Assumptions considered when your scheme puts together a CETV will include:
The cash equivalent transfer value is designed to be a benchmark for how much it would cost to buy the equivalent income from your final salary scheme on the open market, typically using an annuity.
Given annuity rates are very low currently, it takes larger and larger sums of pension capital to buy the same income. As such, cash equivalent transfer values have increased considerably in recent years.
Another reason for the rise in CETVs is the fact that some pension schemes are running into trouble when it comes to meeting their liabilities. Record low yields on government bonds and generally poor investment returns since the financial crisis have hampered funds’ ability to earn returns and so, with these difficulties in mind, pension schemes have been offering higher transfer values to encourage scheme members to leave.
If you are, or have the option to be, an active member of a final salary scheme it will only be in exceptional circumstances (or if you have lifetime allowance protection) that you should consider leaving (or not joining) the scheme.
If you’re in or are offered a place in a final salary scheme and you’ve built up deferred benefits in other schemes, you should check whether your scheme will allow you to transfer those deferred benefits into the scheme.
Whether or not you should transfer your final salary pension depends on your individual needs and circumstances. Many different conditions will have to stack up in your favour before a transfer will be the right option for you. Factors we’ll look at when determining whether or not to give you a positive transfer recommendation include:
If you don’t have any needs that can’t be met by your final salary scheme, then there is little reason to transfer and accept the risk of being worse off in retirement. However, if you do have some needs that a money purchase scheme would provide that can’t be met by the scheme then we can consider whether a transfer might benefit you.
Assuming you do have needs that cannot be met by your defined benefit pension, the second consideration is to ensure you can afford the risks. That’s why we’ll look at your other assets and pension provisions.
If you and any spouse have plenty of other assets – such as property, other pension schemes, cash in the bank etc. – this could be one positive point towards us recommending a transfer. This is providing you’re happy to rely on these assets if the benefits of a transfer turn out to be lower than expected.
On the other hand, if you don’t have much in the way of other assets then a transfer is highly unlikely to be suitable for you, especially if you are solely or mainly reliant on your final salary scheme.
A high transfer valuable could be a reason to consider leaving your final salary pension, but it’s by far the only factor and this alone doesn’t indicate you should transfer.
As mentioned, there are risks involved with a defined benefit pension transfer, not least that the value of your investments and the income they produce could fall as well as rise. If you’re particularly risk averse, then it’s unlikely to be for you given that there’s no investment risk to you personally if you stay in the scheme.
A final salary transfer is unlikely to be suitable for an inexperienced investor with little to no current exposure to investment risk or experience in investing. You’ll have to participate to some extent in managing your money purchase pot in the event of a transfer and have the knowledge to do so.
A shortened life expectancy, perhaps due to a medical condition, may form part of a decision to transfer. You may get more value from your pension from transferring than you would from drawing it for only a short number of years.
However, this involves a projection of your life expectancy – something that can’t be certain aside from with the most serious illnesses. You may live for a long time and find that the guarantee of a lifelong income would have provided greater value.
If you transfer a final salary pension, there’s no going back if you change your mind. You’ll be leaving a scheme that offers security of income for the rest of your (and your spouse’s) life.
Undoubtedly the biggest advantage of a defined benefit scheme is that you’ll receive a guaranteed income for the rest of your life, usually linked to inflation. There’s also typically a widow’s pension for your surviving spouse. You’re giving up both of these major advantages by embarking on a final salary transfer.
High pension transfer values
Cash equivalent transfer values on offer are currently high, ending 2017 largely unchanged from the peak they enjoyed in 2016 according to Xafinity Consulting.
Record low yields on government bonds and rising longevity have played a part in increasing the cost of providing benefits under a final salary scheme, which have pushed up transfer values.
Given poor annuity rates, the figures on offer from final salary schemes have increased to compensate for the fact that you now need far more to buy an income today than you’ve needed previously.
Another reason for rising transfer values has been employers being keen to reduce the risk on their books final salary schemes represent.
A pension transfer will allow you to take advantage of today’s high CETVs, but remember that’s because the cost of providing a pension income has increased sharply, too.
Leaving your pension to your loved ones|
Under the pension freedoms, the tax regime surrounding leaving a money purchase pension to your loved ones became more favourable. Gone is the 55% ‘death tax’ charged on a deceased’s pension. Furthermore, pensions have always been considered outside of the estate and are therefore typically free from inheritance tax.
If you die before the age 75 with a money purchase pension, you can usually leave it to your beneficiaries and they won’t have to pay income tax on any benefits they draw from it. If you die after the age of 75, they’ll be charged income tax at their highest marginal rate.
Greater income flexibility
A money purchase pension invested in a drawdown fund allows you to withdraw lump sums and income as you require (subject to the usual drawdown tax rules). Assuming you have sufficient income to need to use this flexibility, this means you can vary your income each year, potentially helping you stay below certain income tax thresholds in retirement.
As mentioned, if you have a shorter lifespan due to a current medical condition, a transfer may make sense. This is because the final salary transfer value you receive could well buy a higher level of income through an annuity than if you were in good health. Alternatively, you may be able to take a higher level of income from your fund on the expectation that you won’t require an income from it for as long.
Naturally, this works both ways. While there’s a chance you could die early, there’s also a chance you could significantly exceed your life expectancy. A final salary scheme would have to keep paying out in these circumstances, whereas you may find your drawdown money purchase pension runs out.
Worries about the financial health of your employer
Given recent high-profile collapses of firms such as British Steel and British Home Stores (BHS), and the impact this has had on these firms’ final salary schemes, many members are naturally concerned about their pension future.
The risk of your employer going bust and taking your pension with it is a notable concern and one of the major risks to take into account when considering a transfer.
Fortunately, the government has set up the Pension Protection Fund (PPF) to act as the backstop should this occur.
The PPF is funded by a levy charged on all final salary schemes and is there to pick up the pieces should your employer go bust.
If you’re already receiving your pension when your former employer goes bust, you’ll receive 100% of the benefits promised from the PPF. This is likely to be the best option for the majority of people, even when a potential transfer is on the table.
However, it’s worth noting that the PPF puts a cap on the amount you can receive from the fund if you’re yet to reach retirement. This is up to 90% of your entitlement. For a 65-year-old in the 2017/18 tax year, benefits would be capped to an income of around £35,000 per year if they had entitlement greater then approximately £38,000 per year under their scheme.
This could mean those entitled to larger final salary pensions miss out on their full entitlement if their employer goes under and their pension fund winds up in the PPF.
Perhaps the biggest risk of a final salary pension transfer is that you lose out on a guaranteed income for life.
Your retirement benefits may be lower than they would have been in the scheme due to poor investment returns, while securing an income might be more expensive than you thought.
There are no guarantees of an income
A final salary pension provides a guaranteed and typically index-linked income for the rest of your life. Most schemes also contain a provision to continue paying at least a proportion of that income to a surviving spouse for the rest of their life – typically 50%.
You forfeit those guarantees when you move to a defined contribution pension scheme, unless you use the fund to buy an annuity with spouse’s benefits and/or a minimum guarantee period. However, whether you can replicate what you and your spouse would have been entitled to under the scheme will depend on investment returns and annuity rates at the time.
You may be worse off in retirement
Due to the risk involved with investing and the lack of guarantee of a retirement income, you may find that your pension income in retirement is less than you would have received had you stayed in the final salary scheme. Historically, it has been difficult for members to match the retirement benefits the scheme would have provided after transferring out.
You’ll be subject to market fluctuations
The new pension freedoms made income drawdown an option for everyone, no matter how large or small their pension pots are. With income drawdown you leave your pension pot invested and draw lump sums and/or income from it.
However, because your pension pot stays invested this means it’s subject to the ups and downs of the markets. Investments and the income they produce can fall as well as rise, meaning you may therefore get back less than you paid in.
Transfers are final
Once you’ve decided to embark on a final salary pension transfer, there’s no going back. You can’t change your mind further down the road.
What’s more, with a defined benefit scheme the employer would have to make up any shortfall in funding if investment returns are lower than required. With a money purchase scheme, the pensioner would have to make up that shortfall or accept lower benefits.
You’ll be subject to the money purchase annual allowance
The money purchase annual allowance (MPAA) kicks in for those flexibly drawing down a defined contribution pension. This places a cap of £4,000 per tax year on the amount you can continue contributing to pension schemes and still get tax relief. This doesn’t apply to those getting final salary benefits, which means you can continue contributing up to your maximum annual pension allowance into a pension scheme in retirement.
Although there are benefits to a final salary pension transfer, it remains that they’ll only be suitable for a minority of members. To start the discussion about whether leaving your scheme is right for you, call us for advice on 02084327334.
The exact mechanism of how a final salary pension transfer value is calculated is complicated. It involves a number of actuarial calculations and will be based on:
The cash equivalent transfer value you receive — which is the sum of money you’ll get if a pension transfer is right for you and you decide to go ahead — is designed to be a benchmark for how much it would cost to buy the equivalent income from your final salary scheme on the open market, typically using an annuity.
You’ll receive your final salary pension from the date of your retirement for the rest of your life, no matter how long that might be. That’s what makes retaining a final salary pension so valuable.
Even if your employer goes bust at some point in your retirement, the Pension Protection Fund (PPF) will step in. If you’re already in receipt of your pension, you’ll continue to receive 100% of your retirement income from the PPF.
This is opposed to what happens if you transfer your final salary pension to a defined contribution scheme, where the pension pot becomes finite and the money might run out. This could happen if you take too much, too soon, your investments underperform, you live longer than expected or a combination of all three comes to pass.
There have been a number of high profile collapses of British firms in recent years that have hit the headlines, from high street stalwarts BHS and Thomas Cook to Monarch Airlines.
When a firm with a final salary scheme closes, the UK pension lifeboat fund, known as the Pension Protection Fund (PPF) steps in to ensure current and future retirees will receive some if not all of their retirement benefits.
For scheme members already drawing on their final salary scheme, they’ll continue to receive 100% of their promised benefits.
For those yet to draw on their final salary schemes, there’s a cap in terms of how much you can receive in pension income from the PPF, typically set at 90% of what you were entitled to, subject to a cap at a certain level.
Those with larger pension entitlements from a final salary scheme who are concerned about the future health of their employer and are not yet retired may benefit from a final salary pension transfer if available, as the PPF cap could mean you’d get less than you’d be entitled to had your employer not gone insolvent.
Yes, you can technically access your final salary pension from the age of 55 if you want providing your scheme administrator will permit this.
However, when you retire early you might see a reduction in your total pension entitlement compared to if you retired at the scheme’s normal retirement age (NRA). The reduction, if any, will be dependent on what’s known as the scheme’s early retirement factor.
This said, if you’ve been diagnosed as seriously / terminally ill, the scheme may waive the rule that reduces your pension for retiring early depending on the scheme’s rules, your health and other circumstances surrounding your request to retire early.
When you die while in receipt of a final salary scheme, there’s typically an ongoing payout for a surviving spouse. This will be expressed as a percentage of your final salary income, most commonly 50% of what you were previously receiving in life. This widow’s / survivor’s pension is another one of the perks of a final salary scheme.
However, once your spouse dies there’s no further income or cash paid from the final salary scheme. This is because a final salary pension isn’t a pot of money with your name on it; instead it’s a promise from your employer’s pension scheme to pay you an income for the rest of your life only.
This is opposed to a defined contribution scheme, where you have a pot of savings that belongs to you. You can therefore pass a defined contribution pension down to loved ones if there’s cash left at the date of your death.
One reason you may look to transfer a final salary pension scheme is poor health with a limited life expectancy, which could mean you won’t receive as much in the way of income from the scheme as your healthy, longer-lived colleague. In which case, a transfer may make sense in order to benefit from the inheritance flexibilities of a defined contribution pension scheme.
A defined benefit pension will typically pay out a reduced survivor’s or widow’s pension to a surviving spouse / civil partner, or potentially dependent children up until the age of 23 depending on your scheme’s rules. This will typically be a percentage of the deceased pensioner’s pension income, generally 50%.
Other than this, there’s very little scope to leave your final salary pension to your next of kin. This is because it’s not a pot of pension funds with your name on it; rather, it’s a promise from your employer’s pension scheme to pay you an income for the rest of your life.
Choosing to transfer to a defined contribution pension scheme, on the other hand, provides you with a pot of pension funds that you can leave to loved ones and beneficiaries as you see fit.
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