Often referred to as a “gold plated pension”, final salary schemes are a great way to save for retirement. Unfortunately final salary schemes are expensive to sponsor and many employers find they can no longer afford them, so they are a dyeing breed these days.
A final salary scheme is a define benefit pension scheme, so the benefits you can expect to get on retirement are known from the outset. The amount of pension benefit you will receive from a final salary scheme will depend on your salary and how long you’ve been a member.
These schemes are sponsored by an employer. Usually the employer makes generous contributions to final salary scheme, with the employee making smaller contributions. The scheme will usually be run by a board of trustees. They make investment decisions and look after the interest of the scheme’s members.
Crucially, the sponsoring employer is financial responsible for the scheme and must make sure there is enough funding to cover the schemes’ obligations to provide pension benefits to its members.
How final salary schemes work
Usually, both employees and employers pay pension contributions to a final salary scheme. The employee’s contribution will be enhanced by tax relief. These and the employer’s contributions are placed in the scheme’s fund and invested.
When the employee retires the amount of pension they receive will be based on:
The number of years they have been a member in the scheme,
Their final salary (this can be an averaged of the three years prior to retirement), and
The scheme’s accrual rate. This is the proportion of earnings you’ll receive for each year of scheme membership. So, if your final salary scheme has an accrual rate of 60, you will receive 1/60ths of your final pensionable salary for each year you have been a member.
It is usually a good idea to join a pension scheme where employers make contributions, especially if they are generous ones, like a final salary scheme.
Your final salary scheme will probably include death in service benefits, giving you some life assurance cover.
Final salary scheme have a number of advantages, with the main one being that the employer carries the burden of volatile investment returns and increasing life expectancy. If the stock market tumbles, any loss of assets in the pension fund will not affect your pension entitlement.
With a final salary schemes your pension benefits are automatically linked to increases in your salary over the course of your career with your employer.
Usually a good final salary scheme will increase your pension income annually to allow for inflation.
If an employer sponsoring a final salary scheme becomes bankrupt and the asset in the scheme’s fund cannot meet its current and future obligations then scheme members may lose out. However, they may get some compensation from the Pension Protection Fund.
Unfortunately, many employers find that they can no longer afford to offer final salary schemes and are closing their scheme to new members and existing members. In these cases the employer usually switches to a defined contribution scheme where the employee carries the risk of investment performance and annuity rate fluctuations.