Final Salary Pensions

by Adam on August 11, 2010

Pensions shouldn’t be the scary, confusing, or boring. But they are. And for good reason!

They are rarely flexible, have expensive fees, and worst of all, are seen by many as something you start in middle age.

As you’re reading Magical Penny I hope I’ve convinced you that you should be saving for the long term whatever your age but navigating the dizzying array of options out there can be difficult.

Today, I’m beginning to lift the lid on pensions with Part 1 of the Magical Penny Pension series, helping you find the best way to grow your pennies for retirement.

To begin we’ll be looking at the traditional final salary pension.

Final Salary Pensions

The traditional pension of the 20th century was that of a ‘final salary’ pension: Many professional jobs offered such a scheme where every month you and your employer would pay into a ‘pension fund’, an investment account that would grow over time. When you came to retirement, you would then receive a ‘pension’ equal to a proportion of your ‘final salary’ depending on the number of years you have worked at the company.

The great thing about final salary pensions is you can work out how much your pension will be each month.

For example if your company offers you a 40th of your final salary as a pension and you work for the company for 20 years ending on £40k a year, you will retire on half pay (your pension will be: (40000*0.025)*20 =£20k a year).

This type of pension is known as a “defined earnings” pension as you know how much your monthly income will be. You don’t have to know anything about investing but still finish with a comfortable retirement income for the rest of your life.

Another compelling reason to have one is how generous they can be. You do not have to save as much nor take on as much investment risk to secure a good income in retirement. If you wanted to guaratee a £20000 a year income without a final salary pension scheme you would need your pension pot to be hundreds of thousands of pounds.

As it is ‘defined earnings’ it’s the pension fund’s responsibility to pay you what you are promised. Compare this to if you were investing yourself into a pension ‘defined contributions’ -if your investments go down you are out of luck and money, but if a final salary pension fund loses value, the fund goes into debt in order to keep paying you!

Whilst final salary pension schemes have their merits they can also be troublesome:

If the investments in the pension fund do not grow as expected, the pension fund can end up with a deficit (debt). This can cause all sorts of problems and if you have not yet retired some schemes have been known to be ‘creative’ with their calculations on what they are able to pay you as a pension when you eventually do retire.

Also the rules differ on how the final salary is calculated so if you have such a pension make sure you understand it. Some schemes take an average of your salary during the last 5 years, whilst others look only at what you were earning in your last year.

Others still might take an average of what you earned for the past 10 years then divide that by the number of letters in your name, then multiply that by pi. You think I’m joking?

It is worth noting too that there have been been instances where ‘final salaries’ of employees have been cut just before retirement so their final pension is dramatically reduced.

There is therefore an element of luck involved and when we’re talking about the income you will be receiving for the rest of your life who wants that?!

Final salary pension schemes also tend to unflexible and non-transparent. You are likely to have little control over the investments in the fund. There may be instances where you feel uncomfortable not knowing where your money is going each month, particularly if the investments chosen are not deemed ethical by your standards.

Another thing to consider  are costly fees for administration and commissions.You wouldn’t notice them as they come out of the pension fund itself but your company’s investment returns calculations will have included them so the odds are you are getting a lower rate of return than if you had set something else up as your retirement savings vehicle.

Lastly final salary pension schemes can also act as ‘golden handcuffs’ -if you know you will give up a guarateed £20k for life you may be less inclined to leave the company before you retire, even if it would otherwise be the right thing to do for your career, your family, or yourself.

Conclusion:

Final salary pensions work well if you are with a company for many years. But the world is very different now than when such schemes were being introduced in the 20th century.  It is unlikely you will be at your current company for decades. Moving from job to job could result in numerous pension accounts scattered around different providers and final salary pensions are harder to calculate and understand so make retirement planning more difficult.

Final salary pension schemes tend to be quite generous but they are becoming increasingly rare. Companies do not want to take the financial risk of having to pay out the ‘defined earnings’ and adminstratively it is costly, particularly as people are less likely to be at their current job for a lifetime.

Despite their flaws, if your company does offer a final salary pension scheme it makes sense to join given how generous they tend to be. That said, as final salary pension schemes are not always straightforward nor do you have much control, it should not be your only retirement savings strategy.

Thankfully there are many other ways to save that are less complicated, and Magical Penny will detailing them in later posts in the series.

If you have a final salary pension scheme leave a comment if there’s anything you would like to share about it to help other readers!

Previous post:

Next post: