If you have a Final Salary pension, retirement planning can seem more straightforward. However, there are still important decisions that need to be made and it’s crucial that you understand the income it will provide. Whether retirement is just around the corner or some years away, reviewing your pension arrangements can provide confidence.
First, what is a Final Salary pension?
Final Salary pensions, also known as Defined Benefit pensions, are often referred to as ‘gold plated’. This is because your income in retirement is defined, protected and the benefits are typically competitive when compared to the alternative.
With the alternative pension scheme, a Defined Contribution pension, employees and employers make contributions, which benefit from tax relief and is invested. At retirement, pension savers have a lump sum of pension saving that will be dictated by how much they’ve contributed and investment performance. At retirement, they will have to decide how to access the pension and ensure it lasts for the rest of their lives.
In contrast, with a Final Salary pension, the pension scheme takes responsibility for how investments perform, which don’t have an impact on your retirement income. Instead, future pension income is defined from the outset. This is usually linked to how many years you’ve been a member of the scheme and either your final or average salary. At retirement, a Final Salary pension will pay out a regular income for the rest of your life.
Among the benefits of a Final Salary pension are:
- You don’t take responsibility for investments: You don’t need to decide where to place your pension contributions, this is in the hands of the pension scheme trustees. The performance of investments won’t affect your retirement income.
- It provides an income for life: Life expectancy can make planning for retirement challenging, as you don’t know how long pension savings need to last for. With a Final Salary pension, your income is guaranteed for life, taking away this element of uncertainty.
- The income is usually linked to inflation: In addition to a lifelong income, Final Salary pensions are usually linked to inflation. This means your income will rise in line with the cost of living, preserving your spending power in real terms.
- Many Final Salary pensions come with additional benefits: Your Final Salary pension may offer auxiliary benefits that provide peace of mind, such as a pension for your spouse, civil partner or children if something were to happen to you.
As a result, Final Salary pensions can be incredibly valuable for providing certainty and security in retirement.
Calculating your retirement income
The good news is that understanding the income you can expect to receive when you retire is usually straightforward.
How the income delivered from a Final Salary pension is calculated varies between scheme. But this will already be defined. If you can’t find the paperwork detailing this, contact your pension scheme. There will typically be three factors used to define your Final Salary income:
- How long you’ve been a member of the scheme
- Your final salary or a career average
- The accrual rate, this is the fraction of your salary that’s multiplied by the years you’ve been a member of the scheme.
Let’s say you earned £60,000 at retirement and it was your final salary that was taken into consideration. You worked at the company for 40 years and the accrual rate was 1/60. Your income in retirement would be £40,000 annually using the below formula.
Years as a member (40) x accrual rate (1/60) x salary (£60,000)
You should receive an annual statement from your pension scheme, which will include providing a value of your pension at retirement.
Creating flexibility with a Final Salary pension
A Final Salary pension can provide you with security throughout retirement. Yet, you may still want a flexible income to meet your retirement goals. This may be because you plan to spend more in early retirement or at other points. For example, you may have mortgage debt remaining, plan to travel or want to financially support loved ones.
There are ways that you can achieve the best of both worlds.
Many Final Salary pension schemes will allow you to take a one-off lump sum from your pension to kick-start retirement. This will reduce your income during retirement but does provide the capital for flexibility if needed.
Other options include using a Defined Contribution pension to fund a one-off expense if you have one and using your other assets, such as investments, to create a flexible income. It can be difficult to understand how your different assets fit together to help you reach retirement goals. This is an area we can help you with.
Transferring out of a Final Salary pension
If you have a Final Salary pension, you may be considering transferring out.
At retirement, you do have the option to give up the benefits of a Final Salary pension and receive a lump sum instead, which must be transferred to a Defined Contribution pension. There may be some benefits to doing this, such as providing greater income flexibility, but for most people transferring out isn’t the most appropriate option for them.
Receiving a lump sum can seem attractive. However, what you’re giving up, a guaranteed income for life is often more valuable. It’s important to weigh up your financial security and retirement goals before making a decision. If your Final Salary pension is worth more than £30,000, you must take regulated financial advice first.
Please contact us to discuss your Final Salary pension and what it means for your retirement lifestyle. Usually, there are ways to create a flexible income stream that will suit your goals whilst retaining the security one offers.
Please note: Transferring out of a Defined Benefit pension is not in the interest of the majority of people.