Q&A: Final salary schemes

With some companies expected to close their final salary pension plans to new members what does this mean for members of those schemes?

What are final salary schemes?

Final salary schemes give their members a guaranteed percentage of the salary they receive in their last year of work when they retire. The proportion depends on how long the employee has worked with the organisation. An employee who has worked for 40 years and has a typical accrual rate of 1/60th will be entitled to 40/60ths, or 2/3rds, of final salary as an annual pension at retirement.

How many people are in these schemes?

Ten years ago, just over one third of employees were members of final-salary schemes; last year only 15 per cent were. Hit by tougher regulation, greater longevity and market volatility, employers have become less willing to sponsor the schemes.

Of the final-salary schemes that remain, only around a fifth are open to new members, meaning that most employees joining a company with a pension will be offered a definedcontribution scheme.

What should I do if my company says it is winding up its final salary scheme?

The first thing you need to do is check how much the company will contribute on a money purchase basis and calculate if this leaves you with a significant shortfall in your pension expectations. You will definitely need advice if the final salary scheme closes entirely and you have to transfer all your benefits out of the scheme.

What are the issues to consider?

One important factor to consider before transferring out of a final salary scheme into a self-invested personal pension is the value of the ”critical yield”. This is the amount by which benefits will have to grow outside the scheme if they are to match the eventual benefits on retirement that would be received by staying in.

In general, the nearer a person is to retirement age, the higher the critical yield will be - and so the less likely an employee would be able to replicate the growth outside the final salary fund.

For those further away from retirement age, transferring out may be worth it - particularly with many employers now offering enhanced transfer values.

My company hasn’t said it plans to close the final salary scheme but I’m worried, how do I check my employer can deliver the benefits promised?

Even if your employer says it will be able to guarantee your final salary pension then this might change at a later date, particularly if you’re a long way from retirement. For example, your employer could be particularly at risk if it has a large number of older employees coming up to retirement.

Who can advise me on this?

The first people to go to if you’re worried about it are the human resources department. They should be able to tell you exactly how are changes in your pension scheme would affect you. Alternatively, you could try contacting the trustees of your scheme directly. At the same time, it is probably worth speaking to your financial adviser to see if they can shed some light on your options.

What other sort of pensions are there?

The other main option for employers is to offer a money-purchase schemes. With these the amount of pension you will get depends not on your salary, but on the amount you contribute. Both yours and your employer’s contributions are invested and the amount you receive when you retire will depend on the investment’s performance. Some companies are also moving from final salary to average-salary schemes.

Many experts believe money purchase schemes offer a worse deal for employees because they make it more difficult for individuals to assess the level of income they will receive from their pension.

The other thing to be aware of is that employers typically pay less into these schemes. In most final salary schemes staff pay in 5 per cent of salary while employers pay the equivalent of 10 per cent of salary. In most money purchase schemes employees and employers pay in about 5 per cent.

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