No hope for final salary pensions

The writing is on the wall for many private sector final salary pension schemes. If you have one, what does it mean for you?

Back in January, a National Association of Pension Funds (NAPF) survey revealed that around 1,000 private sector final salary pension schemes could fall victim to the current economic crisis, forcing them to close.

In fact, this week, independent policy adviser, Ros Altmann, said just four FTSE 100 companies - Shell, Tesco, Cadbury and Diageo - still offer a final salary scheme compared with 40% five years ago.

NAPF's gloomy forecast appears to be coming true with private sector schemes dropping like flies. Barclays, BP and supermarket chain, Morrisons are some of the latest casualties which have announced closures this month.

Barclays and BP have closed the doors to existing and new employees, and will move to a 'defined contribution' scheme (more on that later). Meanwhile, Morrisons will switch to an inferior average salary scheme where benefits are based on career earnings, rather than members' final salaries.

But the rate of closures is hardly surprising given that many schemes are running huge deficits. Firms are becoming anxious to reduce the liability of providing a guaranteed pension to employees. No doubt we will see plenty more pensions shutting down in the coming months.

How do final salary schemes work?

These top-quality occupational schemes offer employees guaranteed benefits in retirement which are linked to their salary. Usually, the maximum pension is two-thirds of final salary.

Schemes can vary depending on the company running them, but here's a typical example of one of the best types: a 1/60th final salary scheme.

Let's say you're in a scheme with a 1/60th accrual rate*. This means for every year of service, you'll earn 1/60th of your final salary as a pension. So, if you work for the full 40 years (service beyond this won't count), you'll build up an entitlement of 40/60ths. This gives you the maximum pension you can earn under the scheme - two-thirds of your final salary.

If you had a final salary of say, £30,000, you would get a pension of £20,000 a year in retirement (40/60 x £30,000).

Final salary schemes are so attractive because these benefits are guaranteed, and the employer bears all the risk in providing them.

But the huge cost of guaranteed pensions is forcing many firms to move over to 'defined contribution' (DC) schemes instead. However, with this type of scheme, there's no way of knowing what the benefits might be at retirement.

What is a defined contribution (DC) scheme?

Remember that ordinary personal pensions are a type of DC scheme. In simple terms, you know how much you're putting in the pension, but you don't know how much you'll be getting out at retirement. That's because DC schemes are normally invested in shares, and therefore the value of the pension fund when you retire is heavily dependent on stock market returns.

It's usually down to you, the employee, to decide how to invest your pension contributions. In this way, you take on all the risk of how well it performs. If the stock market investments you choose do badly, your pension will suffer.

At retirement, the pension fund is normally converted into an income using an annuity. The amount of income you receive depends on annuity rates. If rates are low at that time - as they are now - the pension will generate a lower level of income. But the reverse is also true should annuity rates improve.

So, a DC scheme involves taking a gamble on the stock market and on prevailing annuity rates at retirement. Who knows what level of pension you might eventually end up with?

What happens if your final salary scheme closes?

If this happens, you'll most likely be moved over to a DC scheme. Although, some schemes may water benefits down by switching to an average salary basis, like Morrisons.

But what happens to the benefits you accrued before the scheme closes?

Well, let's say you have 20 years service, and you're in a scheme with a 1/60th accrual rate. You'll still benefit from the years you already have under your belt before the closure. Your pension will then be 20/60ths or one-third of your final salary when you retire.

If your final salary is taken as £30,000, you would get a pension of £10,000 a year in retirement (20/60 x £30,000), based on 20 years service.

When a scheme closes before you reach retirement, your final salary will normally be calculated by linking your current salary to the retail prices index, RPI, or increasing it by 5% a year - whichever is lower. This ensures your final pension is inflation-proofed and maintains its purchasing power.

What happens if you have already retired or you have left the company?

Don't worry if you're already drawing a pension from a final salary scheme which closes. You should carry on receiving the same pension income every month regardless. If you left the company in question and you have a 'frozen' final salary pension, then, when you retire, you should receive the same benefits based on the number of years you accrued before you left.  

The prospects for final salary schemes are looking pretty dismal, unless you work in the public sector, where schemes are funded by the taxpayer, and haven't been hit anywhere near as hard by the economic crisis.

Unfortunately, if you have to move over to a DC scheme, the chances are your pension at retirement will be significantly lower than the benefits you would have received from your guaranteed scheme. So bear that in mind when you plan for your financial future.

*Note that schemes can offer different accrual rates

Read more pensions and retirement articles here.

More: Help! I can't afford a pension | Why delaying your retirement makes sense


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