Final salary schemes

Final salary schemes have long been the golden egg of pensions as they guarantee members a certain payout on retirement without them having to shoulder any investment risk. But these schemes have dominated the headlines in recent weeks as some of the UK’s leading companies have taken action to plug mounting costs. As life expectancy rises and investment returns fall, members of these schemes may face less generous pensions than they had hoped for.

So what exactly are final salary schemes?
Final salary schemes are a “defined benefit” pension – employees and their employers pay a monthly percentage of the employee’s salary into the pension in exchange for a guaranteed retirement income, which is traditionally based on the level of earnings at retirement date. Employee contributions are usually between 4 and 8 per cent of salary, while employer contributions average 16 per cent, according to the National Association of Pension Funds.

How valuable are these schemes to employees?
Final salary schemes are viewed as the most lucrative schemes employees can get. The investment risk lies entirely with the employer – no matter how the underlying assets perform, the company is obliged to pay the agreed benefit.

The amount of retirement income under these schemes depends on how long you have worked for your employer, your earnings prior to retirement and the scheme’s accrual rate – the proportion of salary that is received for each year of service. So, if the scheme has an accrual rate of 1/60th, you would receive 1/60th of your final pensionable salary for each year of service.

The downside of these schemes is that you do not have your own pot of money – your pension depends on how well funded the scheme is and the financial health of your employer.

How widely are these schemes offered now?
Many companies have closed their defined benefit schemes to new members and replaced them with defined contribution schemes in which the retirement income paid out depends on how much you have put in, how well the fund has performed and the long-term interest rates when you retire.

The number of private sector final salary schemes closed to new members has increased to 57 per cent from 10 per cent in 1997. If you are about to join your employer’s scheme it is more likely that you will go into a defined contribution scheme.

Why has there been a shift away from final salary schemes?
These schemes have been hit by increasing life expectancy, falling long-term interest rates, lower investment returns and an increasing regulatory burden. Many companies are now facing spiralling pension deficits.
What can companies do to control the deficits?
There are several options available to companies looking at reining in the costs of final salary schemes.

Apart from winding the scheme up completely, the most radical action is to close the scheme to future accruals, as Rentokil announced last year. It is more likely that companies will try other ways of minimising the risk, such as closing the doors to new members or watering down the terms on future benefits.

Your employer could make you pay more into the scheme – Arcadia last week said it wanted employees to pay 2 percentage points more – or delay your retirement date.

It could also change the accrual rate of the scheme – the proportion of your pensionable salary that is received for each year of service. For example, this could move from a rate of 1/60th – ie. getting 1/60th of your final salary for each year of service – to a level of 1/80th or even 1/100th.

These changes will not affect past benefits you have accrued within your pension scheme – these will be paid under the original terms – but employers do have a lot of freedom to change the terms surrounding future benefits.

How is my pension calculated?
Historically the pension is based on either what you earn in your last year of service or the average salary of the last three years. Some companies are likely to move towards career average plans, which base the retirement income on your average salary during your career. The Co-operative Group last week said it would introduce this type of scheme to replace its current final salary terms.

What protection do I have if my company goes bust?
Previously, if your company went into insolvency you could be at risk of losing your entire pension benefit. But last April the Pension Protection Fund was introduced, to pay members who have reached retirement age 100 per cent of their benefits, with no cap. Members who have not yet retired will receive 90 per cent of their projected benefits up to an annual cap of £25,000. This protection is funded by a charge on all defined benefit schemes.

What benefits do I get if I leave my company early?
You have two options. The first is to keep what you have already paid into the scheme with your old company. Your employer will calculate the pension due to you and this will be increased in line with inflation, up to a maximum of 5 per cent each year.

Alternatively, if your new employer offers a good scheme, you could obtain a transfer value and put this into a new scheme with your new employer.

How can I find out how safe my scheme is?
You can get information on how well funded your scheme is by contacting the scheme’s trustees.