How do final salary pensions work?

Chris Torney / 29 April 2016

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Until recently, the most common type of company pension was the final salary scheme. This kind of pension guaranteed employees an income in retirement that was linked to how much they earned in work and their length of service.

But over the last couple of decades, final salary schemes have become increasingly scarce and today very few employers provide them – especially in the private sector. This is largely because of the expense of offering such pensions and, in particular, the fact that the future costs associated with these schemes can be very unpredictable.

As a result, today’s workers are likely to get much less generous workplace pensions than their predecessors.

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How final salary pensions work

Members of final salary schemes typically accrue a proportion of pension entitlement – often 1/60th – for every year they are in their jobs. 

When they reach retirement age, the company works out how many years’ entitlement they have, and this – combined with their salary level at retirement – determines the size of their annual pension.

For example, someone who worked for 40 years at the same firm would have accrued 40/60ths (or two-thirds) of their final salary. So if their earnings at retirement were £42,000 a year, their pension under the scheme would be £28,000.

To pay for this pension, their employer would have made monthly deductions from the employee’s salary over the 40 years – these would have been invested in the stock market and other assets in order eventually to generate the pension income.

But if these investments did not grow sufficiently to generate £28,000 a year, it would be up to the employer to make up any shortfall out of its own profits.

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Where final salary pensions started going wrong

Towards the end of the last century, serious problems relating to final salary pensions began to emerge, each related to the cost employers faced in providing such schemes.

Firstly, there were significant improvements in life expectancy in the UK, which meant that final salary pensions had to be paid out longer than before. 

Secondly, the returns on the investments held by final salary schemes started to fall. This factor was not helped by new administrative rules brought in which forced companies to rely to a greater extent on lower-risk assets such as government bonds. The change was designed to make pensions safer, but it also led to a fall in investment growth rates.

The upshot was that companies had to find more money out of their own coffers to subsidise pension scheme shortfalls. In some instances, this had a dramatic impact on the ability of businesses to carry on trading.

As a result, many firms started to close their final salary schemes in a bid to cut costs and stay solvent.

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Closing final salary schemes

When a company decides it no longer wishes to run a final salary pension, it has a few options. It may simply decide that it will not offer such pensions to new staff, while allowing existing workers to continue paying into and benefiting from the scheme.

Alternatively, it can close the pension to new accruals, so no one could put more money in or build up extra pension entitlement – so if you had worked for 15 years when the scheme was closed, you might eventually be entitled to a pension worth 15/60ths of whatever your salary was at the time the scheme was shut.

Less drastically, the employer might decide to link the pension to a career average salary rather than each worker’s final salary. It could change the scheme retirement age – raising it from 60 to 65 could help the firm reduce costs – or reduce the rate at which entitlement is accrued, for example by cutting from 1/60th a year to 1/80th.

Anyone who is already taking their pension under a final salary scheme is unlikely to be affected by any such changes, however.

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Replacing final salary schemes

Where final salary pensions have been phased out, they have generally been replaced by defined contribution (DC) schemes, also known as money purchase pensions.

These involve workers putting aside a certain proportion of their salaries every month, along with a contribution from their employer, to make stock-market investments. These investments are then used at retirement to generate a pension income, either by buying an annuity or by leaving the money invested while making regular withdrawals.

The key difference with DC pensions is that the level of pension income depends on investment performance and is not guaranteed by the employer.

By switching from a final salary scheme to a DC pension, the risk that investments might do badly is transferred from the company to the employee.

DC schemes are today far more common than final salary pensions.

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Pensions in the public sector

Although most final salary schemes have disappeared from the private sector recently, this kind of pension is still common in the public sector with the likes of teachers and doctors continuing to have their pension income guaranteed by the government.

But even state-backed workplace pensions have been watered down, at least to some extent, over recent years. For example, the retirement age in some professions has been raised, and the government has decided that annual increases in pension payments should be linked to what is normally a lower rate of inflation in a bid to reduce the pressure on the public purse.

However, it seems likely that final salary schemes in some form will remain available in much of the public sector for the foreseeable future.

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The opinions expressed are those of the author and are not held by Saga unless specifically stated.

The material is for general information only and does not constitute investment, tax, legal, medical or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.