A short guide to Final Salary pensions
This is the fourth post – and the longest – in a short series of blog posts this week which will explore the often confusing world of pensions in a bit more depth. You can read the first three posts here, here, and here.
What is a final salary pension? A final salary pension is a defined benefit pension, although not all defined benefit pensions are final salary. Many active defined benefit pensions today are career average pensions, otherwise known as CARE. Defined benefit (DB) pensions pay a guaranteed income for life when you retire, regardless of how long you live. The amount you will receive each year is based on a percentage of your final or average salary (known as the ‘accrual rate’) multiplied by the number of years you have been a member of the pension scheme (your ‘length of service’). Accrual rates are typically 1/60th or 1/80th. So, if somebody has a final salary pension with an accrual rate of 1/60th and is a member of their workplace pension for thirty years then at retirement they would have accrued 30 x 1/60th. That’s half their final salary to you and me. By contrast, the alternative to a defined benefit (DB) pension is a defined contribution (DC) pension, often referred to as money purchase pensions. A DC pension does not provide a defined income in retirement, and does not offer guaranteed income for life. Rather, the contributions you make and the contributions your employer makes are invested. What you receive in retirement depends on how much your pension pot is worth at retirement, and how you choose to take these benefits when you retire. So, a defined benefit pension provides guaranteed income for life, while a defined contribution pension carries investment risk. Most pensions are DC (defined contribution). For instance, any private pension – personal pensions, stakeholder pensions, SIPPs – are defined contribution. Most modern workplace pensions are too, as increases to life expectancy has made the cost of providing defined benefit pensions unsustainable, and the acceptance of an unknown liability unattractive, for most employers. However, many people will have preserved benefits in older final salary pensions, and it is still common today for many public sector workers to have defined benefit pensions. For instance, people working in the NHS, the police, the armed forces, and many civil servants, local government employees, and people working in education such as teachers, lecturers, and support staff will still have current defined benefit pension schemes in place.
How much will my pension pay me? Well, this depends on how long you have been a member of the pension scheme, and what your final salary or career average salary is. If you are a member of a defined benefit pension, whether active or ‘preserved’, then you should receive a benefit statement each year which will tell you the income you should receive in retirement. If you aren’t sure, you should ask your employer or former employer for more information. It is important to remember that, while the guarantees offered by defined benefit pensions are valuable, this does not mean the amount of income or benefits will be greater than an equivalent defined contribution pension would provide. It simply means that the amount you will receive is defined by your length of service and the accrual rate, rather than being dependent on investment performance. Somebody saving the same monthly amount into a defined contribution pension over the same number of years could replicate the benefits of a DB pension, although as the amount they will receive depends on how investments perform they could have more or less. It is the guarantees offered by defined benefit pensions, and the lack of investment risk for the individual, that make final salary and career average pensions valuable.
When will my pension start? This is an area where defined benefit pensions do differ quite substantially from defined contribution pensions. With a defined contribution pension, like a personal pension or most private sector workplace pensions, you can almost always access your pension at any age from age 55 onwards. There is no penalty for accessing your pension early, although it does mean your money is invested for less time. With a defined benefit pension, there will be a specific age from which you can access benefits. This is known as the Normal Pension Age or Normal Retirement Age. For older DB schemes, this could be as young as 60, while many schemes now will have a Normal Pension Age that is tied in with your State Pension Age. This does not mean you cannot access benefits sooner. Allowances can be made for ill health, and in any case you are usually able to access benefits sooner or later than the Normal Pension Age, although typically this is restricted to a period of five years sooner. This means somebody with a DB pension with a pension age of 65 could take benefits from age 60. This will depend on the ‘scheme rules’; that is, the rules of the pension scheme you are or were a member of. If you can access pension benefits earlier than the Normal Pension Age, the benefits you receive – that is, the amount of income paid to you each month – will be reduced to reflect the longer period the pension will be in payment for. This is known as an actuarial reduction. It is important to consider whether the benefit to retiring sooner than anticipated outweighs the reduced income you will receive each year for the rest of your life.
Tax-free cash This is another area where DB and DC pensions differ quite substantially.
A defined contribution pension will usually allow you to take out 25% of the pension pot tax free. This is valuable as, while pension income is taxable income, the tax-free lump sum is… free of tax. While this 25% rule also applies in theory to defined benefit pensions, calculating the exact amount is complicated as you don’t have a defined pension pot in the same way as a DC pension saver would; instead, you have a defined income or benefit entitlement. As a result, each DB scheme will have a calculation it uses, known as a commutation factor, to arrive at the sum of tax-free cash available. A commutation factor of 10 would mean that, for each £10 of tax-free cash you take as a one-off lump sum, you trade away £1 of income each year. Each scheme will have its own commutation factor. If you are unsure, you can ask the pension scheme to provide its commutation factor to you. While tax-free cash is great, with a DB pension it is important to remember that you are trading guaranteed income for life for upfront tax-free cash. You should always consider whether the reduced income meets your needs before taking your tax-free lump sum.
Keeping pace with rising costs Now, this is one area where DB pensions are really prized, and is one of the key reasons they are considered ‘gold plated’. Unlike a DC pension, defined benefit pensions have inbuilt mechanisms to make sure your pension income keeps pace with rising costs, such as inflation or wage growth. This can be replicated with a defined contribution pension – for instance, by purchasing guaranteed income with an annuity policy which will increase each year, or by using a ‘drawdown’ strategy which aims to provide you with a sustainable sum of income each year while allowing the remainder of your pension pot to remain invested and generate investment returns – but unlike with DB pensions this is not an automatic feature of the pension arrangement. So, with a DB pension, you can take comfort in the knowledge that, once your pension is in payment, the amount of income you will receive each year will increase. This could be by a fixed amount, or it could be in line with inflation. It is often the case that different types of benefits within the DB pension will increase by different calculations. This annual increase is known as escalation. As well as this escalation once in payment, it is also the case that benefits are increased each year to keep pace with rising costs if you leave the pension scheme before you reach retirement age. This means that somebody leaving an employer, and therefore the employer’s pension scheme, before retirement will also benefit from annual increases even though they are no longer accruing pension benefits based on their length of service. This is known as revaluation. A further benefit of escalation and revaluation, particularly when a fixed rate is used, is that these fixed rates were often set back when inflation typically ran higher than today. This could see your benefits increasing by a fixed rate of 5% each year, when anticipated inflation is around half of this at 2.5%.
What happens if you die Well, this is another area where DB pensions are quite different to DC pensions. In this instance, it is defined contribution pensions which can often be more attractive. Firstly, it is important to remember that pensions – whether defined benefit, defined contribution, or ‘hybrid’ schemes which incorporate both DB and DC – are usually outside of your estate when you die. This means that the benefits or wealth you hold within pension arrangements do not count towards your Inheritance Tax allowance, and therefore pensions offer a means to pass wealth down the generations while mitigating the tax that is payable. However, DC pensions offer a far greater range of options for passing benefits to family and loved ones when you die. These options are usually referred to somewhat bluntly as the ‘death benefits’. By contrast, a defined benefit or DB pension is more restrictive. While the rules differ from scheme to scheme, it is typical for a DB pension to offer only, at most, two forms of death benefits once it is in payment – a spouses pension, and a childrens pension. While the rules differ from scheme to scheme, it is usual for a surviving spouse to have an entitlement to a proportion, often 50%, of the benefits you would have received. This means a surviving spouse will continue to receive half of the income you would have received for the remainder of the surviving spouse’s life. Any children, too, may also have an entitlement to a proportion of your benefits – often 25% per child – if you die while your pension is in payment. However, children’s pensions are not a feature of all DB pensions, and where they are then it is usually only available until the child or children reach the age of 23, at which point the benefit stops. If your children are already over the age of 23 at the point you die, no benefits are paid. Exceptions may be made for children that would have remained financially dependent, for instance due to physical or mental impairment. Why is this more restrictive? Well, first of all, a spouses pension usually only applies to married partners or civil partners, and in the case of the latter – or if you have remarried or have a significantly younger surviving spouse – there can be further complications and restrictions. If you are cohabiting but not married or in a civil partnership, then your surviving partner would not typically retain any entitlement. Likewise, if you are single or if you die after your spouse or civil partner, then no spouses pension is payable, and if you do not have children, or your children are already over the age of 23, then no childrens pensions are payable. This differs from the death benefits potentially available to DC pension savers, which offer a much wider range of options, potentially allowing benefits to be passed down the generations or to unmarried partners, adult children, or anybody the pension saver wishes to nominate. There is also one other significant difference between the death benefits available in DB pensions and DC pensions, and that is in their tax treatment. While both pensions are not typically considered part of your estate when you die, and therefore are not usually subject to Inheritance Tax, the benefits you pass on may be subject to income tax. In the case of defined benefit pensions, the benefits you pass on to a surviving spouse or any children under the age of 23 are always treated as taxable income regardless of the age at which you die. This means that the income paid to the surviving spouse or children will be subject to income tax at the highest rate at which the surviving spouse or children pay tax. By contrast, if you die before the age of 75 then benefits in a defined contribution pension can be passed to whoever you wish tax-free, provided the benefits are designated within a two-year window. It is only once you reach the age of 75, or if the benefits are not designated within two years of your death, that the recipient pays income tax on these benefits at the highest rate of income tax they pay.
Pension Freedoms and Pension Transfers Pension Freedoms is the name given to new rules, introduced from 2015, which were intended to give people greater choice about how they accessed their pension wealth. Prior to 2015, pension savers were either in DB schemes, and would therefore receive a scheme pension based on length of service and accrual rate at retirement, or in DC schemes which largely restricted them to purchasing an annuity policy from an insurer when they wanted to retire. An annuity policy in effect replicates a DB pension, as it will provide a guaranteed income each year, usually for the remainder of the annuity policy holder’s life. However, unlike with a DB pension where the scheme pension is automatic, a DC pension saver using an annuity instead exchanges their pension pot as a lump sum at retirement for a guaranteed income for life, and therefore the amount of income they will receive each year depends on the ‘annuity rate’, or the cost of annuity policies, at the point they retire. Pension Freedoms changed this, allowing pension savers greater choice about how and when they accessed their pensions in retirement. This greater range of options allows people choices about when they retire, and about who benefits in the event of their death. Pension Freedoms also allow people greater ability to only take the income they need, and therefore manage the tax they pay. These freedoms have benefited many, although there are risks involved too, including investment risk and the risk of running out of money in your lifetime. You can read more about the options available under Pension Freedoms here. However, this greater freedom applies to defined contribution pensions, not defined benefit pensions, which remain largely unchanged. The potential negatives of this are that DB pension savers may have less choice about when they retire, less control of how much income they receive once they retire and therefore less ability to manage the tax they pay, and less choice about who benefits in the event of their death, if anybody benefits at all. Nonetheless, it is important to consider these potentially negative factors against the positive factors of guaranteed income for life, indexed or escalated each year to keep pace with rising costs, with a guaranteed pension for life for any surviving spouse or civil partner.
So how do DB pension savers benefit from pension freedoms? Well, for those pension savers who are still in employment with a defined benefit workplace pension, then a smart move is to also save for your later years in a DC pension alongside the DB pension, for example by regular monthly contributions to a personal pension. This means that you retain the valuable benefits and guarantees a defined benefit pension provides, while also having a separate pension pot available at retirement which offers the greater flexibility and range of choices and options provided by DC pensions. This can be really important if you want to retire sooner, as you can use the DC pension and the tax advantages pensions offer to meet any shortfall between the age you want to retire and the age at which you start to receive DB or State pension income. It can also be a valuable way to ensure your family and loved ones can receive a tax-efficient lump sum benefit in the event of your death. Having a separate pension pot can also allow you the choice to take ad-hoc lump sums in retirement to supplement your defined benefit pension income while also still benefiting from possible investment returns on this pension pot and from the guarantees offered by the DB pension. Another option is to transfer some or all of your benefits from a defined benefit pension to a defined contribution pension. The transfer of benefits from a DB to a DC pension is known as a ‘pension transfer’, as opposed to a DC to DC transfer which is usually known as a pension switch. Pension transfers are a specialist area, with a statutory requirement for all pension savers with a total DB pension pot equivalent to £30,000 or more to seek appropriate independent advice from a financial adviser. What’s more, not all financial advisers can offer this advice, as it requires specialist advanced qualifications such as the Chartered Insurance Institute’s AF7 qualification and the Financial Conduct Authority’s Pension Transfer Specialist designation, as well as costly insurance for the advice firm and a sufficiently robust compliance regime. For these reasons, the majority of financial advisers and advice firms are not able to provide regulated advice about pension transfers. You should also note that this option to transfer from DB to DC is not necessarily available to you, as DB pension savers in ‘unfunded’ pension schemes – that is, pension schemes which are supported not by a group pension fund but are instead funded by central government, such as the NHS pension scheme or the Teachers pension scheme – are not able to transfer. Likewise, even when the scheme allows transfers out, this is only available to pension savers before retirement. Once you have retired, or are within twelve months of the normal age at which benefits are paid, there is no statutory requirement for the scheme to allow you to transfer benefits to a DC pension arrangement. In addition, and crucially, great care should be taken when considering a transfer of safeguarded benefits, such as a transfer from a defined benefit to a defined contribution pension arrangement. While you may gain greater flexibility, this is at the expense of the loss of the valuable guarantees DB pensions offer. This can be a complicated area, although the key point to consider is that there is no investment risk for the individual within a DB pension scheme; by transferring to a DC arrangement, the individual takes on investment risk and therefore the risk that returns could be lower than expected, that the capital itself could suffer losses, and that the individual could run out of money during their lifetime. By transferring to a DC arrangement, the individual also takes on the costs of the pension arrangement, which are funded by the sponsoring employer in a DB scheme, and is likely to have a greater need for ongoing financial advice, which will necessarily involve further costs. It is because of the value of the guarantees offered by defined benefit pensions that the Financial Conduct Authority’s stance is that all advice on the transfer of benefits from DB to DC arrangements should start from the assumption that the transfer will be unsuitable. This does not mean a transfer is always unsuitable, as there are scenarios when a transfer makes sense. There may be reasons and factors specific to the individual that mean a transfer is appropriate - for instance, somebody with three DB pension arrangements, of which two of these three already provide more than sufficient guaranteed income for their needs in retirement, may be an appropriate candidate to transfer the benefits of the third DB pension to a DC arrangement, to benefit from the greater flexibility this would offer. Likewise, other factors which may result in a transfer being deemed suitable could be an individual with a wish or need to retire sooner than would otherwise be possible, or with a wish or need to take advantage of the more flexible death benefits DC pensions offer. People who are single may want to transfer as there is no benefit to the spouses pension, and those in ill-health, who will not live long enough to benefit from the guaranteed lifetime income, could be better off transferring. It is precisely because it is a big decision with significant potential consequences for the individual that there is a requirement for DB pension savers to seek appropriate advice from a suitably qualified pension transfer specialist working for a firm with the correct authorisations, permissions, and insurance cover. While a pension transfer is the right decision for some individuals, it is not a decision to be taken lightly!
A final salary pension is a form of defined benefit (DB) pension.
Another common type of DB pension uses career average earnings instead of final salary. This type of pension is known as a career average pension, or a CARE pension.
·Defined benefit pensions provide income in retirement based on your length of service (the number of years you were a member of the pension scheme) x the accrual rate (typically 1/60th or 1/80th of pensionable salary for each year of service).
·DB pensions are always occupational pensions provided by employers.
This type of pension arrangement used to be more common, but is now largely restricted to the public sector such as the NHS and teachers, although some private sector pension schemes do still accept new members.
·Even when new members are not accepted and new accrual has ended, many people will have built up pension benefits in a DB pension. This is known as a preserved pension.
·While there are some drawbacks to this type of pension, chiefly around their inflexibility, DB pensions are often referred to as ‘gold-plated’ due to the valuable guarantees they offer, such as guaranteed income for life which will increase each year to keep pace with rising costs.
·Defined contribution (DC) pensions offer greater flexibility in a number of ways, but carry greater risks.
·Decisions to opt-out or transfer away from a DB pension should not be taken lightly, and will usually require you to seek advice from a qualified specialist with advanced technical qualifications known as a Pension Transfer Specialist.
·The FCA is clear that the starting point should be that a transfer of safeguarded benefits from a DB to DC pension will not typically be suitable.
·However, there are scenarios where a transfer can make sense – but make sure you take advice from somebody you trust with the appropriate technical knowledge, qualifications, expertise, authorisations, and permissions.
·An alternative way to benefit from the flexibility of DC pensions without trading away the valuable guarantees of a DB pension is to begin saving into a personal pension or stakeholder pension alongside accruing benefits in a defined benefit pension through your employer. This can allow you greater control over when you retire, your lifestyle in retirement, and who can benefit in the event of your death.
IMPORTANT NOTES: This blog post is not financial advice and is not specific to any individual. This article is intended as generic guidance and comment only, and does not constitute any form of financial or investment advice or recommendation, which is always specific to individual needs. You should not take any actions on the basis of this article, and should take appropriate professional advice instead. This post was published in April 2020. Legislation and policy may change over time. All blog posts are written by Dylan Roberts in a personal capacity and do not necessarily reflect the views of Lighthouse Financial Advice Ltd, Lighthouse Group, Quilter Financial Planning, or Quilter plc.