What is a final salary pension?
A defined benefit pension scheme – sometimes called a final salary or career average pension scheme – is one that promises to pay out an income based on how much you earn when you retire.
Unlike defined contribution (DC) pensions, the amount you’ll get at retirement is guaranteed, and it will be paid directly to you – you won't have to use your pension pot to decide your next move.
This guide explains how final salary schemes work and how you can work out how much income you could get in retirement.
What are the different types of final salary pension?
If you've saved into a final salary pension scheme, your savings, along with the contributions of your employer and the tax relief you receive from the government, have been invested in the stock market over your working years.
But the income you ultimately receive from your pension is a guaranteed, pre-agreed amount. This is why they are called 'defined benefit' pensions.
There are two types of defined benefit pension.
- Final salary schemes, which are based on how much you're paid when you finally retire
- Career average schemes, which are based on an average of your salary across your career.
Both types of pension provide valuable benefits, the biggest of which is something called 'index-linking'. This means that your pension income is guaranteed to rise each year so it can keep up with rising prices in the future.
This protection is usually capped at 2.5% a year, although, in some cases, it's linked to the Retail Prices Index measure of inflation.
Other benefits of final salary pensions
Other benefits of final salary pension schemes include:
- death-in-service payments to spouses, partners or dependents if you die before reaching pensionable age
- full pension if you have to retire early through ill health
- reduced pension if you retire early, although this can’t be done before the age of 55.
Private sector v public sector final salary pensions
Defined benefit pensions have historically been provided by both private companies and public sector organisations.
Final salary pensions are in decline, but millions of people still hold them. According to the Office for National Statistics, 1.3m people are actively contributing, and 11.8m have a DB pension they will be able to claim in future.
If you hold a private sector DB pension, you have the right to request a transfer, as do members of so-called ‘funded’ public sector schemes. In a funded plan, contributions from the employer and employee are invested in a fund towards meeting the benefits.
Some public sector schemes, such as those for teachers, NHS workers, the armed forces, the civil service, police, and fire service, aren’t linked to specific pension funds (they’re paid out of general taxation). These are known as ‘unfunded’ DB pensions.
These schemes cover somewhere in the region of five million UK residents.
How do I work out my final salary pension income?
If you've saved into a final salary pension scheme during your career, it will provide you an income for your retirement based on three key factors.
The number of years you have paid into the scheme; your salary – this might be your final salary when you retire or your average salary across your career sand your pension scheme's 'accrual rate'.
This is a formula that's used to calculate your final retirement income. This 'accrual rate' is a fraction of your salary (usually 1/60 or 1/80), and it’s multiplied by the number of years you’ve been in the scheme.
Let's look at how this works in practice:
- Your final salary when you retire is £30,000.
- You've worked at your company for 40 years.
- Your company uses an accrual rate of 1/60th.
- Your annual pension would be £20,000 (40 (years) x 1/60th (accrual) x £30,000 (final salary).
Use our final salary pension calculator
Can I take a lump sum from a final salary pension?
When you retire, the government rewards you for saving into a pension by allowing you to take 25% of your savings completely tax-free.
This is commonly called a lump sum, and taking it will reduce the amount of income you receive from your pension.
With final salary pensions, the way this is calculated is complicated. It's based on the scheme's 'commutation factor', which represents how much of a lump sum you get for every £1 you give up in income.
So if you have a commutation factor of 12, you get £12 of lump sum for every £1 you give up.
You will need to contact your pension scheme to find out how much lump sum you will get from your final salary pension.
Find out more in our guide to taking a lump sum your pension.
Can I cash in or transfer my final salary pension?
As part of the April 2015 pension freedoms, you may be permitted to transfer from a private defined benefit scheme to a defined contribution pension (after taking regulated financial advice).
This has transformed the retirement plans of thousands of people and produced a sharp rise in savers transferring their defined benefit pensions to defined contribution schemes.
However, opting to cash in a DB scheme is not a decision to be taken lightly. It is for good reason that the FCA has taken a keen interest and warned advisers to take a very cautious approach when talking to potential transferees.
A guaranteed income for life via a DB scheme remains the gold standard for pensions. Forgoing this opens up the possibility that you’ll have less to live on than expected – and you could even run out of money altogether.
Find out more in our guide to transferring your company pension.
What happens to my pension if my company goes bust?
Some people have cited concerns about their scheme going bust as a reason to consider transferring away from their final salary pensions and all the benefits that it can bring.
However, to protect members of insolvent employers where there is a shortfall in the pension scheme, the Pension Protection Fund (PPF) was established by the government to cover schemes that fail from April 2005 onwards.
Find out more in our guide to the Pension Protection Fund.
Final salary pensions: FAQ
Why are final salary pension schemes closing?
Final salary pension schemes are advantageous for members because the scheme takes all the investment risk and is obliged to meet the 'pension promise' of a pre-defined amount of income made to each member, regardless of how underlying investments have performed.
This means final salary pension schemes are risky for employers and are also becoming more expensive as people live longer because they have to pay out for longer.
For these reasons, most private sector schemes have now been closed to new members and replaced by defined contribution schemes.
Does a final salary pension die with you?
No – there are usually spousal or partner rights to your pension.
Final salary pensions will normally pay a reduced pension of around 50% to your spouse or a dependent child when you die. Deciding how much the survivor will get depends on when you die and the scheme you’re in.
If you are already receiving income from your pension, and are married or have a registered civil partner, they will normally continue to receive a reduced pension payment after your death.
Some schemes may also pay out a lump sum if you die in the early years of your retirement.
Scheme rules will detail what benefits are payable and who would be classed as dependents or beneficiaries.
How is a final salary transfer value calculated?
If you do decide to transfer your final salary pension, the amount you get to invest is known as the 'cash equivalent transfer value', which is calculated by your final salary scheme.
The cash-equivalent transfer value is basically the amount of money your pension scheme would need today to make sure it could cover the cost of the benefits you were guaranteed to receive in the future, were you not to cash them in.
Traditionally, transfer values have been calculated as a multiple of around 20 times the annual income due at retirement.
For example, a final salary pension worth £10,000 a year would produce a lump sum of £200,000. More recently, transfer values of 30-40 times the final salary benefits have been offered.
Is my final salary pension taxable?
Income from a final salary pension is taxable along with other types of retirement income, including the state pension.
The money you receive from private pensions (either directly from an employer's pension scheme or from annuities bought with your pension funds) is paid with tax already deducted via PAYE.
Your tax office sends your pension provider(s) your tax code so it knows how much to deduct, but it's always advisable to make sure you receive a copy of the code for each source of PAYE income to check your tax.
Our guide details how you pay tax on your pensions.
Can I take my final salary pension early?
Final salary schemes will usually have a ‘normal retirement age’ (the age at which you can start taking your pension), which is often 60 or 65.
The normal retirement age for public sector pensions will vary depending on the scheme you’re enrolled in, and when you joined it.
The scheme rules may allow for retirement before the normal age – you’ll need to check.
If early retirement is allowed, it generally results in a significant reduction in annual pension payments. The annual value of a pension taken at age 55 will often be approximately half that expected if retiring at 65.
How is my final salary pension valued for the lifetime allowance?
The pensions lifetime allowance is a limit on the value of money from your pension schemes that can be made without triggering an extra tax charge. The limit has been set at £1,073,100 for 2022-23 and then until 2026.
Your private pension contributions are tax-free up to certain limits. However, if your pension pot is worth more than the lifetime allowance you will pay additional tax on it.
You can work out whether you are likely to be affected by the LTA by adding up the expected value of your lifetime pension income.
With final salary pensions, you calculate the total value by multiplying your expected annual pension by 20.
So you are likely to be impacted by the 2022-23 LTA if you are expecting to receive an annual income (with no separate lump sum) in the region of £53,655 a year.
Find out more in our guide to the pensions lifetime allowance explained.