Final Salary, (Or Defined Benefit) Schemes Explained.



Posted on: 20th November 2014

As a member of a final salary scheme you secure a percentage of your leaving (or final) salary. Lets use a 60th scheme for example (bear with me!). If you work for the company in question for 15 years you secure 15/60th (or 25%) of your final salary.

Lets say you earned £20,000 at the time of leaving. £20,000 x 25% = £5,000.00 at date of leaving.

This defined benefit is then increased annually to help inflation proof its true value over the ensuing years until your normal retirement date. This is a small but important fact if your normal retirement date is date is 20 years away!

The increases are typically CPI to a max of 3% – 5%, lets use 5% in our case and normal retirement date is two years away. £5,000 x 105% = £5,250.00 (one year) x 105% = £5,512.50 (two years).

So, you get to retirement age and the scheme has a promise to honour a pension income of £5,512.50 pa (which will increase annually in payment and include a 50% dependants pension). This all sounds fairly straight forward (well, almost). You, as the member (or deferred member) take no investment risk over these years and all the risk is laid firmly at the door of the scheme to ensure they have the funds to buy your income promise.

That’s where it gets interesting. These promises were not difficult to fund when investment returns and interest rates were 10 – 15% in the 80’s and 90’s. However, as returns on assets like gilts (loans to the government) has steadily declined over the past 26 years you have needed larger and larger sums of money to secure the same income promise.

In fact today, £100,000 of pension funds would secure just £2,850.00 pa for an increasing pension income with a 50% Spouse’s pension in the event of death.

Using our initial example you would need a fund of £193,420.00 to secure £5,512.50pa based on almost all time low annuity rates! As such transfer values on these schemes have rocketed over the past couple of years.

These increases are by no means guaranteed to continue to rise. In fact any rise in annuity rates could significantly reduce the funds needed to meet the income promise. Lets look at a few examples:

£5,512.50 income based on an annuity rate of 2.85% = £193,420.00 required to fund the income.

£5,512.50 income based on an annuity rate of 3.50% = £157,500.00 required to fund the income.

£5,512.50 income based on an annuity rate of 4.50% = £122,500.00 required to fund the income.

You can quickly see how a scheme’s liability’s can reduce as annuity rates increase. Annuity rates are at all time low’s presently. At some point they are going to increase. If you are in a final salary scheme stick with it!

If your a deferred member it might be worth obtaining a Cash Equivalent Transfer Value (ring HR of the company and they will point you in the right direction). You may well be surprised by the figures contained therein!

Importantly then seek Independent Financial Advice to assess its merits. I’m not advocating that everyone leaves their Final Salary arrangement’s, far from it. I’m just pointing out that what goes up can come down.