This content is for information and inspiration purposes only. It should not be taken as financial or investment advice. To receive personalised, regulated financial advice please consult us here at Elmfield Financial Planning in Padiham, Burnley, Lancashire.
The UK has many types of pensions – adding to common confusion about retirement planning. Broadly speaking, there are three to consider: the State Pension, defined contribution pensions (i.e. pension “pots”) and final salary – or “defined benefit” – pensions. This latter category can be especially important given the attractive benefits these schemes typically offer. Yet some people wonder how their final salary pension works, and if they should transfer to a different scheme.
Below, our financial planning team in Padiham, Burnley, Lancashire offers a short guide to final salary pensions, how they work and what to consider when debating a transfer. We hope this content is useful to you. If you’d like to speak to an independent financial adviser then you can reach us via:
T: 01282 772938
Overview to final salary pensions
Final salary (defined benefit) pensions work differently to other pensions. The State Pension bestows a retirement income to you based on your National Insurance (NI) contributions and is funded out of UK taxation. A defined contribution pension involves building up a “pot” of money – perhaps with your employer via a workplace pension – to fund your retirement lifestyle. A final salary pension, however, is offered by some employers and pays you a guaranteed retirement income, typically until you die.
Such schemes are increasingly rare in 2022, but are still offered by certain sectors such as policing and teaching. They are sometimes called “gold plated” because they can offer attractive benefits, such as linking your income to inflation (thus preserving your spending power even as the cost of living rises). Employers in the private sector are often now reluctant to offer final salary pensions, partly because people are living longer and also due to higher job mobility.
The advantages
Final salary pensions are widely seen as the “best” type of workplace pension. As such, the Financial Conduct Authority (FCA) advises that most people will benefit most from keeping their scheme rather than transferring out of it. One great benefit is that your pension scheme income should not fluctuate each month. With a defined contribution pension, for instance, your income may vary depending on your investment performance. With a final salary pension, however, the employer is obliged to pay you a set amount each month. Any investment underperformance is shouldered by the employer.
The fact that final salary pension income is often inflation-linked is also a powerful benefit which should not be overlooked. If inflation rises by, say, 2% each year (the Bank of England’s target rate) then this requires your savings and investments to grow by at least 2% just to keep up with the rising cost of living. With a final salary pension, however, this is often not a worry. Finally, a final salary pension is often guaranteed for life. Whilst a defined contribution pension could run dry without careful management (e.g. due to overspending in retirement), a final salary pension means that you do not need to worry about running out of money.
Why a transfer can be suitable
Final salary pensions should be held dearly by most people planning for retirement. However, they do have downsides to consider. First of all, many of these schemes are fairly old and have not caught up with the Pension Freedoms introduced in 2015. These allow individuals to access their defined contribution pension pots from the age of 55 (rising to 57 in the future). Many final salary pensions, however, do not offer this flexibility. This can be highly restrictive for people who may wish to retire early.
Secondly, final salary pensions cannot be inherited in the same way as pension pots – although they might offer certain (often reduced) “death benefits” to a surviving spouse if the scheme member dies. A defined contribution pension can be passed down to loved ones – e.g. children – without facing inheritance tax (IHT). This means that pension pots can often be used not only for retirement planning purposes – but also estate planning, to reduce an IHT liability. However, the beneficiaries may still need to pay income tax on any pension money inherited, if the deceased was over 75 when he/she died. Finally, in rare cases an individual may consider a transfer if they want to retire abroad (taking their pension “with them” via a QROPS).
Overall, a final salary pension can be a vital pillar in an individual’s pension plan – providing stability and peace of mind in retirement. For instance, suppose your scheme guarantees you a £16,000 annual income (linked to inflation). In addition, you have also built up your full new State Pension which provides about £9,339 in 2022 (also linked to inflation). Even setting aside any cash savings, ISAs or pension pots, these two pensions, alone, could provide £25,229 per year to live on. This could be plenty depending on your financial situation and retirement goals.
Invitation
If you are interested in starting a conversation about your own financial plan or investments, then we’d love to hear from you. Please contact us to arrange a free, no-commitment consultation with a member of our team here at Elmfield Financial Planning in Padiham, Burnley, Lancashire.
Reach us via:
T: 01282 772938
