My Final Salary Pension: What is it & should I Keep it?
Perhaps you are starting to think about retirement, have spoken to your employer and realised you have a “final salary pension”.
What does that mean?
Maybe you have gone on to do some research and have noticed that some people have talked about “transferring” onto a different type of pension.
Is that a good idea?
At Castlegate, we help clients in Grantham and across Lincolnshire to answer these kinds of questions. It can really pay to work with an independent financial adviser, to help you sort through the issues and identify the best options available to you.
However, you are also more likely to get more out of your conversations with financial advisers if you are equipped with important information about pensions beforehand.
In this article, we’re going to help you equip yourself by providing a short, simple guide to final salary pensions and outline some of the advantages and disadvantages of transferring.
Please note that this content is for information purposes only, and should not be taken as financial advice. To receive tailored advice into your own specific situation, please speak to a professional financial adviser.
Final Salary Pensions: An Overview
A pension is designed to provide you with an income in retirement. However, there are different types of pensions and they each provide a retirement income in a different way.
The most common type of pension these days is called a “defined contribution pension”, which is usually arranged via your workplace. Here, both you and your employer build up a pension “pot” over time, which you can then access after the age of 55.
In your case, however, a “final salary” pension (sometimes called a “defined benefit” pension) operates differently. Rather than building up a pot of retirement savings, your employer’s financial salary scheme instead promises to pay you an annual income when you eventually retire.
The precise amount you get depends on a range of factors, such as how long you worked at the company and what your salary was. Some schemes will use your pre-retirement salary when calculating the income they will eventually give you. Others will use your average earnings during employment over a period of time, when doing their sums.
It gets more complicated when you drill down into the details, but that is essentially how it works. It’s worth mentioning that this type of pension is becoming increasingly rare, because they are quite expensive for companies to afford. With people now living longer and changing careers more frequently, businesses are also often now more likely to go down the defined contribution route instead for their pension schemes.
Due to their rarity, final salary pensions are sometimes called “gold plated” as many people see them as the best pension deal on offer. Yet the reality is that some people have opted to transfer their pension to another type of scheme. Why is that?
Part of the reason lies in the government’s new pension freedoms, introduced in 2015. These generally give people on defined contribution pensions much more flexibility in how they can use their pension, which has tempted some people to transfer.
Transferring is a big decision, and not one to be taken lightly. Once you move from a final salary scheme to another pension plan, you cannot go back. In addition, it is almost always impossible to completely replicate the benefits of your final salary scheme elsewhere. So you need to be absolutely sure that transferring will offer you a more appropriate retirement solution, before you move.
In general, most people will probably not benefit from a pension transfer. Yet in certain cases, it can be the better option. The important thing is to make sure you seek independent financial advice from a professional who has experience in this area, first.
Let’s briefly look at some of the reasons why certain people might want to transfer their final salary pension, and then some important reasons not to.
When you transfer your final salary pension, your scheme administrators assess the value of the benefits and give it a cash value (“cash equivalent transfer value”). You can then invest this into another type of pension, such as a personal pension or SIPP (self-invested personal pension).
Perhaps the biggest advantage of moving to a fund or money purchase based scheme is that you can one day pass this “pension pot” onto your loved ones as an inheritance. Final salary schemes cannot generally be inherited by your children (although your spouse might continue to receive a fraction of your scheme benefits if you die before him/her).
Having a pension pot also gives you easier access to cash, particularly as you can take up to 25% from your pot as a tax-free lump sum after the age of 55. You can usually take a lump sum from your final salary pension, but it can be quite a complicated process.
By transferring, you also eliminate the risks attached to your final salary pension if the company paying it were to go bust although there is a degree of statutory protection from the Pension Protection Fund.
However, bear in mind that even if you transfer, your new pension pot would likely be invested and this is not risk-free either – its value may go up or down depending on the performance of what you invested in.
The big advantage of final salary pensions is that they usually provide a guaranteed income for life, which rises in line with inflation so that you can keep up with the increasing cost of living.
A defined contribution pension pot, on the other hand, runs the risk of your income going down (or even running out) if your investments underperform. The sequence of investments returns is also an important factor as poor returns early on in retirement causes your pension pot to deplete more quickly, forcing you to reduce your pension income or risk exhausting your pension pot.
You could try and replicate this “guaranteed income” by transferring your final salary pension into a pension pot, and then using this money to buy a financial product which gives you a guaranteed income (i.e. an “annuity”). However, the income that this will pay out will likely pale in comparison to the income your final salary pension would provide on a “like for like” basis, although for some people this can be a better option.