Understanding Final Salary (or Defined Benefit) Schemes

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havenifa


Posted on: 16th Aug 2018

If you are a member of a final salary scheme, you will secure a percentage of your leaving (or final) salary. For example, if you were part of a 60th scheme and have worked for the company for 15 years, you will secure 15/60th of your final salary. To put it in simpler terms, you will receive 25 per cent.

Your Final Salary Pension: The Maths

Let’s assume that when you left your company, you earned £20,000. 25 per cent of that would be £5,000, which is what you would receive at the date of leaving. This defined benefit then increases on an annual basis, which will in turn help inflation-proof its true value over the upcoming years until your normal date of retirement. Though this is a small fact, it is extremely important to know if your normal retirement date is in 20 years.

In most cases, the increases are CPI to a maximum of 3 to 5 per cent. For our example, we shall use 5 per cent and a normal retirement date that is two years away. So, 105 per cent of £5,000 will be £5,250. This will be for the first year. In the second year, you will be calculating 105 per cent of £5,250, which will be £5,512.50.

So, you finally reach your retirement age and the scheme must honour their promise of a pension income of £5,512.50 pa (something which will increase on an annual basis in payment and include a 50 per cent dependant’s pension). For the most part, this seems rather simple to understand. As a member or a deferred member, you will take no risk of investment over these years. What’s more, all the risk is laid securely in the scheme to ensure that they have the funds to keep their promise.

An Increasing Need in Savings

This is where things take an interesting turn. It was relatively easy for businesses to fund these promises in the 80’s and 90’s. Back then, investment returns and interest rates were somewhere between 10 and 15 per cent. Returns on assets such as gilts (loans to the government) have been on a steady decline in the past 26 years. As a result, the need for more money to secure the same income promise has increased over the same period.

Today, pension funds of £100,000 would secure only £2,850 pa for an increased pension income with a 50 per cent spouse’s pension in the event of death.

With our initial example, in order to secure £5,512.50 pa, a fund of £193,420 is required. This is based on almost all-time low annuity rates, as such transfer values on these schemes have soared over the past couple of years.

However, there is no guarantee that these increases will continue to rise. In fact, any annuity rates that rise could reduce the necessary funds to meet the income promise at a considerable rate. Here are some examples to help further your understanding:

  • £5,512.50 income based on an annuity rate of 2.85% = £193,420.00 needed to fund the income
  • £5,512.50 income based on an annuity rate of 3.50% = £157,500.00 needed to fund the income
  • £5,512.50 income based on an annuity rate of 4.50% = £122,500.00 needed to fund the income
  • It is easy for you to see how the liabilities of a scheme can shrink as annuity rates rise. Annuity rates are currently at all-time lows. At a certain point in time, they are going to rise. It may be a good idea to stick with your final salary if you are a member of one already.

It is worth making a note that in the event of an employer becoming insolvent, all final salary pension schemes are protected by the Pension Protection Fund. As a deferred member, it may be worth looking into any cash equivalent transfer value as you get towards NRD. These figures are not always guaranteed to continuously rise as we have previously demonstrated. However, the promise of income will remain consistent.

Talk to Haven IFA

If you would like to learn more about final salary pension schemes, then get in touch with Haven IFA. Our team of experienced financial advisers are here to provide you with the necessary advice for saving for an enjoyable retirement.