Final Salary Schemes and Defined Benefit Schemes
Final Salary Schemes, also known as Defined Benefit Schemes, and sometimes shortened to DB schemes. If you have been a member of a final salary scheme for over two years, you will be entitled to a small fraction of your salary for each year of your employment. The fraction is known as the pension scheme’s “accrual rate”.
The bigger the fraction, usually, the better the pension scheme. These schemes are often referred to by those fractions. For example, a scheme that provides 1/80th of your final salary per year can be called “an eightieth” scheme. After forty years in “an eightieth” scheme, you would be entitled to 40/80ths – in other words one half – of your salary when you leave/retire.
But, if you joined “a fiftieth” scheme instead; you would get to half of your salary after only 25 years. By the way, that’s the parliamentary pension scheme.
The pension you receive is related directly to the time you spend in the scheme and your salary, so there is no need to rely on investment performance. Investment performance is your employer’s problem.
These days, final salary pension schemes tend to be referred to more by the name defined benefit. This is partly because of the change towards basing pension on a ‘career averaged-salary’ instead of a ‘final salary’. For most people, salary is at its highest in the final few years before retirement. Costs can be reduced by averaging the salary over a longer period – for example your whole career.
Running a defined benefit can be expensive for an employer, because they have to pay in whatever it costs to provide the fraction of salary for each year. That can be expensive in times of high inflation or low investment growth. Employees usually make a contribution towards those costs, by paying a fixed percentage of salary. However, the majority of the cost is met by the employer, and this is the amount that fluctuates.
Members have limited control over the way the funds are invested. Your own ethical/religious considerations may not be reflected in the management of the fund.
You might want to keep that pension within the final salary pension scheme when you leave because the pension scheme delivers inflation-proofing, so you don’t have to worry about inflation. “But”, sometimes the inflation-protection is capped, meaning that the scheme can’t cope with high inflation. If you’re not confident that you understand exactly what inflation-proofing your scheme provides, fill in our enquiry form for help.
Pension transfer – occupational pension – what to do after you have left a final salary scheme
If you join a new employer, who also provides a final salary scheme, it might be possible to transfer your frozen pension benefits into the new scheme. However, this may not be as good an idea as it first seems. It’s very rare for the new scheme to honour the same number of years/days as the old one and there are technical reasons for this, mostly to do with the differences in salary expectations, scheme benefits and inflation. For example, would one year in the eightieth scheme in have the same value as one year in that fiftieth scheme? Would two schemes with the same “accrual rate” really have the same value if you joined one on a salary £2,000 higher than your salary when you left the old one? And, will inflation present the same threat if you are actively a member of the scheme and still earning, than it would if the pension is preserved?
If your new role is starting your own business, you may be interested in the fact that your pension fund can be used to purchase commercial property. Your pension can also borrow to buy a bigger commercial property, but there are rules to limit the amount your pension can borrow. To do any of this, you would need to give up those valuable benefits and extract your benefits from the final salary scheme. Is it a good idea to do that? Make sure you value every bit of your preserved pension before you decide to give up its benefits.
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