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In 2023, there are an estimated 6,400 “gold-plated pensions” (final salary pension schemes) in the UK. Yet this figure pales in comparison to the number of schemes which are built upon pension “pots – also called defined contribution pensions.
Indeed, 0nly 1,013 final salary schemes remain fully open to employees, and 200 have closed since a year ago. They are increasingly rare, mainly available to public service workers like teachers and police officers, due to the costs to the organisations offering them.
Below, our Burnley financial advisers explain how final salary pensions work, how defined contribution pensions compare to them and ideas to integrate these schemes into a wider retirement plan. We hope these insights are helpful to you.
Please get in touch for more information or to discuss your own financial plan with us.
What is a final salary pension?
The main difference between a final salary pension and a defined contribution pension is that the latter involves building up a “pot” of money. The former does not; instead, the scheme from your employer promises to pay you a guaranteed income when you retire.
In this respect, a final salary pension can be seen as similar to the State Pension. Both offer a lifetime income upon reaching the required legal age. Neither involves managing a pot of investments which you have built up over a career.
However, the two are different. A final salary pension is offered by a former employer, with the income determined by factors such as your career earnings and years of service. The State Pension, by contrast, is provided by the government and the income is largely based on your National Insurance (NI) record.
A final salary pension is sometimes called a defined benefit pension. However, the former may calculate a former employee’s retirement income based on their salary at the point of leaving their job. The latter may, instead, base the calculation on the person’s average career earnings.
What is a defined contribution pension?
Today, most UK employees will be building up a retirement pot with their employer via their workplace scheme. This is called a defined contribution pension and staff are opted into the scheme by default upon entering employment with the organisation.
However, a defined contribution pension does not necessarily need to be attached to an employer. An individual can set up their own scheme, called a personal or “private” pension, if this suits his/her needs and goals. However, an employer will not be obliged to pay into it.
In 2023-24, an employee must pay at least 5% of their salary into their workplace pension scheme. The employer needs to contribute at least 3%.
How do final salary pensions and pension pots compare?
It is fair to say that final salary pensions are widely regarded as amongst the best types of pensions available in 2023 (hence the name “gold-plated”). Their benefits can be very attractive and are difficult to replicate with other options in the pensions market.
In particular, the guaranteed lifetime income offered by these schemes can be an immense source of peace of mind for those in/entering retirement. You do not need to worry about the scheme running out of money. Moreover, you can rest assured that the Pension Protection Fund (PPF) will compensate you if your scheme provider goes bust.
However, final salary pensions do have drawbacks. One issue is that the scheme member is usually quite limited in which benefits can be passed down to beneficiaries, after death. There may be some reduced income available to certain dependents (e.g. 50% to your surviving spouse). However, you cannot leave a lump sum of money.
By contrast, a defined contribution pension can let an individual leave a pot of money to their loved ones after death. Moreover, the funds are passed down without inheritance tax (IHT), making these schemes very useful tools in financial planning – not just for retirement planning, but also for estate planning.
Defined contribution pensions also offer members more control over their underlying pension investments. They are also highly flexible. For instance, an individual might choose to take 25% of their pot as a tax-free lump sum after reaching their Normal Minimum Pension Age – using some of the remainder to buy an annuity and/or go into drawdown.
However, these schemes do carry the risk of running out of money if not carefully managed. Underlying investments can rise and fall over time – affecting how much money an individual can withdraw, sustainably, from their pension pot(s).
For those with a final salary pension, there is the option to transfer it to a defined contribution scheme if you want to access its benefits (e.g. passing down an IHT-free pension pot to beneficiaries). However, the Financial Conduct Authority (FCA) requires that individuals seek financial advice when considering this decision, depending on the pension’s value. A transfer can be a good choice for some people, but it is not right for everyone.
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
