Final Salary (or Defined Benefit) Schemes Explained

Final salary pension schemes are often interpreted as among the most complicated on the UK market as a whole. Nevertheless, just as soon as you get to grips with the very basics of how they work, you actually begin to find they’re not nearly as complicated as they may appear on the surface.

In the simplest of terms, if you have a final salary pension scheme in place, this basically means that you lock in a proportion of the salary you are being paid at the time you retire from your job. In the example of a scheme whereby one 60th of the individual’s final salary was to be locked in, if they were to work for this same company for a period of 15 years, this would mean 15 years multiplied by the one sixtieth of their final salary, equating to 25% of their salary at the time of their retirement.

As such, if their final salary upon retirement was to be £20,000, 25% of this final salary would be £5,000.

In order to cope with inflation, the defined benefit amount undergoes an annual increase in order to ensure that its true value remains right up until the date the individual in question retires. These annual changes will of course in most instances be somewhat minor, but given the fact that in many cases the policy holder may be 25 years from their own retirement, the difference quickly adds up.

For example, in the instance of an individual whose retirement will take place in two years, they may receive an annual increase up to a maximum of 5% CPI. This would mean that after one year, their final salary pension of £5,000 at 105% would be £5,250, and after two years would be £5,512.50. This would therefore mean that the final salary pension scheme they were enrolled in promises them £5,512.50 on an annual basis throughout their retirement.

At this point it all sounds relatively simple – it is those providing a scheme such as this who take all the risks and there is technically no risk for the policy holder, regardless of what might happen during the years leading up to retirement. However, it’s not quite as straightforward as it seems and as interest rates and returns on assets like government loans (gilts) continue to scrape along at rock-bottoms, it’s becoming increasingly difficult but certain businesses to actually make and come through with these kinds of promises.

With the way things stand right now, in order to secure £2,500 per year it would require pension funds of a lofty £100,000. Or going back to the example detailed above, in order to secure this payment of £5,512.50 annually, total funds required would hit a huge £220,500. Annuity rates have been hovering at all-time lows for quite a few years now, which in turn has led to an explosive increase in cash equivalent transfer values (CETV).

Of course, there’s absolutely no guarantee with regard to which way things are going to head in the future – things have a habit of swinging in either direction with little to no advance warning. Take into account the following few examples as to how annuity rate increases could lead to a marked reduction in the kinds of funds required to fulfil promised income:

£5,512.50 per year with an annuity rate at 2.8% = £220,500.00 needed to fund the payments.
£5,512.50 per year with an annuity rate at 3.50% = £157,500.00 needed to fund the payments.
£5,512.50 per year with an annuity rate at 4.50% = £122,500.00 needed to fund the payments.

So it’s pretty easy to see just how enormous the impact on liabilities even the most modest of increases to annuity rates can be. As already mentioned, annuity rates offer for the time being just about the lowest levels they have ever been, which means that sooner or later they are bound to increase. Or in other words, the general consensus among independent financial advisers is to stick with any final salary scheme you may currently be a part of.

Of course there are instances in which it could be beneficial to think about Cash Equivalent Transfer Values the closer you get to the country’s national retirement date as there are no concrete guarantees as to which way things will go.

Assessing A Transfer

In order to assess any potential transfer accurately and thoughtfully, it is important to do so in conjunction with the advice and assistance of a reputable independent financial adviser. The scheme administrators should be asked for a “Statement of Entitlement” which should be offered free of charge once every 12 months. This is the document that will detail current transfer value and payable benefits. All such information must be analysed and considered carefully with a trained pension transfer specialist adviser, in order to establish any potential benefits of moving, risk, potential losses and cost incurred. The critical yield must also be analysed, which represents the projected return on the investment which must be achieved following all charges in order for the retirement benefits provided to be equal to or greater than those of the DB scheme.
Final salary pension schemes have the potential to be extraordinarily beneficial and rewarding, depending on personal circumstances and various market conditions. Arrange a consultation with an independent financial adviser for more information and guidance.