Final Salary Pension Schemes Explained



Posted on: 12th July 2016

Confused by the idea of a final salary scheme? Rest assured, you’re far from the only one! With so many retirement benefit schemes available these days, it can be difficult to get to grips with which makes sense for you – or even make sense of them at all.

As for final salary schemes, it’s essentially a case of securing a percentage of the salary you were on at the time of your departure. In a working example, you may work for any given business for 15 years and leave at the age of 60. This would mean that you’d be entitled to 15/60th of your final salary, meaning 25%. As such, if your salary at the time of leaving was £40,000, this would mean your final salary scheme sum would be £10,000. What this then means is that your annual pension allowance would be £10,000.

The final figure you come out with doesn’t stay fixed, however. Instead, it increases on an annual basis in order to cope with inflation. This is crucially important in the instance of an employee that leaves their job at the age of 40 or 50, who would then have to wait up to 20 years or so to access their final salary pension. More often than not, the amount increases by 3% to 3.5% per year, in order to ensure those involved in these kinds of schemes don’t miss out.

Which means that when you get to retirement, your final salary pension annual allowance will be considerably more than it was at the time you left your job – if you left your job a long time before retirement. Otherwise, it will be closer to the true figure. What’s also interesting about final salary pensions is the way in which those involved in them technically face no kind of investment risk whatsoever – all the risk is shouldered by the businesses offering them.

These days, it’s not quite as attractive for businesses to offer final salary pensions as it was 20 or 30 years ago. The reason being that interest rates and investment returns have plummeted since then, meaning firms are having to stump up more of their own cash than ever before to fund such schemes. As such, in order to take home approximately £5,500 per year in pension funds through such a scheme, you’d actually first be looking at paying a whopping £220,000 into your pension pot.

On the plus side, annuity rates attached to final salary schemes are at the lowest rate they’ve ever been. Why is this a good thing? Quite simply because that can and will only go up from here…eventually. As such, the advice from most experts to those with final salary schemes in place is to stick with them.

You can quickly see how a scheme’s liabilities can reduce as annuity rates increase. Annuity rates are at all time lows presently. At some point they are going to increase. If you are in a final salary scheme, stick with it! Cash Equivalent Transfer Value is definitely worth considering on the run-up to retirement, but should only be considered under advisement from an experienced, independent professional.