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60 second guide to final salary pensions

New code discourages pension switch incentives

Members of final salary pension schemes should be very wary of pension switching.  

A new industry code aims to stop employers offering cash incentives to staff with final salary pensions to encourage them to leave the scheme. Although voluntary, the code has been welcomed by Pensions Minister Steve Webb, who wants it to be adopted universally.    

Our 60-second guide explains how final salary pension schemes work, how they differ from other pension schemes and why transferring out of one is hardly ever a good idea.

What is a final salary pension scheme?

A final salary pension scheme is one that pays you a defined benefit (DB), in this case pension income linked to your final salary and the number of years you’ve belonged to the scheme. The higher your salary and the longer you have been a member, the more you get. 

Defined benefit pension schemes used to be common in the private sector, but in recent years most have closed to new members, with many closing to existing employees too. 

Final salary DB schemes are still common in the public sector, but have been criticised as being too expensive. It has been suggested that the amount they pay should be linked to ‘career average’ salaries.

Why are final salary pensions special?

The big difference between final salary pensions and money purchase (defined contribution) pensions is that, for the individual concerned, final salary pensions are very low risk. Money paid into the scheme is invested, but the trustees are bound to pay out the final salary ‘promise’, regardless of what sort of return it makes. 

In defined contribution (DC) pension schemes, risk is transferred to the individual member – whose eventual pension depends on how well the investments have done and what sort of annuity they can buy. 

Final salary pension schemes also tend to be index-linked, so protect their members against inflation, and contain an element of life insurance that delivers a spouse’s pension if the main holder dies. 

What’s wrong with transferring out of a final salary pension? 

Companies with final salary schemes have historical liabilities that can be extremely expensive. Many schemes are currently ‘under funded’ and need regular injections of cash to remain stable. 

In order to reduce this burden, some trustees offer incentives to scheme members to transfer out. This can take the form of an ‘enhanced valuation’ of the member’s pension assets and an additional lump sum paid out immediately. Although transfer offers of this kind can be tempting, they have been criticised as undervaluing the final salary benefits members are entitled to. 

The risk of transfer is considerable – with members who move having to take their chances on the market rather than relying on a predictable pension promise. Falling annuity rates add to the uncertainty of transferring to a money purchase scheme.

What does the new code say?         

Developed by the Institute and Faculty of Actuaries, Association of British Insurers (ABI), DWP and National Association of Pension Funds (NAPF), the new code bans cash incentives that are dependent on acceptance of a transfer offer. It also calls for scheme members to be offered regulated and qualified independent financial advice. 

The code addresses concerns voiced by Pensions Minister Steve Webb earlier this year when he said: ‘We urgently need to make sure that we root bad practice out of the market. The industry can’t go on offering superficially attractive deals to people that ultimately leave them badly out of pocket.’

‘I am very concerned that people are making the wrong choices about their pensions and are missing out on substantial amounts of retirement cash.’ 

What should I do if I’m offered a pension transfer deal?         

Although the sums on offer can seem tempting, anyone who is offered an incentive to leave their final salary scheme should think carefully and take independent financial advice. 

Which? pensions expert Ian Robinson said: ‘There are circumstances where a transfer could make sense (someone with very short life expectancy, for example) but most people will be better off leaving well alone.’ 

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