Should I Transfer into my Employer’s Final Salary Scheme?

A Transfer Into a Final Salary Scheme is Rare…

The opportunity to transfer into a final salary (defined benefit) pension scheme is an increasingly rare and valuable one. Final salary schemes deliver a guaranteed level of income in retirement that’s based on your number of years service and your salary when you leave the scheme or retire.

This means that any subsequent pay rises you might receive will automatically increase the value of your final pension, which adds to the appeal of this kind of transfer. The pension you receive will run from retirement until the day you die, the benefits will usually be linked to inflation and, upon death, there will typically be a reduced (50%) widow’s pension.

As it’s based on your years of service and salary, a transfer into a final salary scheme will most likely result in you being awarded ‘additional years’. This is because most schemes operate with an ‘accrual rate’ of, for instance, 1/80th or 1/60th of your salary for each year of service, subject to a scheme maximum.

The income you’ll get from a defined benefit pension is based on three factors:

• Number of years you’ve been with that employer and contributing to the DB scheme
• Your pensionable earnings (for final salary schemes, this is your salary at retirement; for career average schemes, this is your mean salary across your career)
• Your pension scheme’s accrual rate (the proportion of your earnings you’ll receive for each year spent in the scheme, usually represented as a fraction, e.g. 1/80th).

The common calculations for working out how much your final salary pension is worth are:

The beauty of a final salary scheme is that the investment risk rests with your employer, not with you. This highlights how, if it’s a guaranteed level of income that’s most important to you in retirement, there’s nothing better than a good final salary scheme pension.

Such schemes also tend to offer additional benefits such as death in service payments if you die before reaching pensionable age, a potentially full pension in the event of ill health early retirement and a reduced pension for early retirees from age 55.

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Even so, there are a number of pros and cons. Most notably, money purchase (defined contribution) pension schemes offer far greater flexibility when it comes to managing your pension benefits, including the opportunity to pass your unused pension wealth onto your beneficiaries.

In the case of a final salary scheme, once you and your spouse have died the pension ends, regardless of how much your ‘fund’ may have been worth or how long you may have drawn benefits.

Final salary schemes also offer little flexibility when it comes to taking tax-free lump sums. Essentially, you have one opportunity to take (usually) up to 25% as a tax-free lump sum, the remainder of your ‘pot’ is then invested to deliver your income.

It’s also a relatively expensive option compared to taking a lump sum from a money purchase pension. Thanks to the ‘commutation factor’ that final salary schemes apply, any lump sum represents a sacrifice of future income.

Most schemes tend to have commutation factors of between 12 and 14 which means that for every £12 to £14 of lump sum you might take, you sacrifice £1 of annual income for the rest of your life. This is less than half the comparable annuity rate, despite the fact that annuity rates are currently very low.

However, the opportunity to accrue generous pension benefits without shouldering any of the investment risk is not to be missed and for most people if you have the opportunity to be part of a final salary scheme you should take it up without hesitation.