2. Final Salary Schemes

How do they work?

These are also known as “defined benefit schemes”. Such schemes tend to be offered by larger companies and are usually considered a valuable benefit as part of an overall employee remuneration package. Membership of a Final Salary Scheme is not compulsory and eligibility can be restricted to certain classes of employee.

A pension scheme is established under a ‘trust’ quite separate from the Company and looked after by a set of trustees whose job is to run the scheme as required by the trust deed and rules governing the scheme, taking advice where necessary. Legislation has been introduced to prevent misuse of the pension funds by the Company. There is now the right for members to elect trustees and procedures have to be in place to settle disputes. Where the employer has become insolvent and a Scheme commences wind up after 6 April 2005 without sufficient funds to meet its liabilities, The Pensions Protection Fund, which was established in 2005, gives some protection. Prior to 6 April 2005, provided certain conditions were met, some protection was offered by the Financial Assistance Scheme.

Final Salary Schemes promise a certain level of pension when you retire. Typically the scheme may require a member contribution, with the employer contributing the balance required to fund the benefits. It is likely that the Company contribution will be substantially greater. The level of benefits available to specific members depends on a number of factors including years of service, pensionable earnings and scheme basis. The final benefits available are subject to Inland Revenue maximum benefit limits.

Benefits

Benefits are usually calculated in relation to length of service and the level of salary on leaving the scheme. Many schemes in the private sector give pensions of 1/60th of final salary for each year of service to give maximum benefits after 40 years service. In the public sector the pensions are usually calculated at 1/80th with a separate 3/80th tax free lump sum, which gives a similar overall result. Pensions in payment can increase in order to offset the effect of inflation. New pension benefits are currently required to include inflation protection up to a maximum of 2.5%. Some schemes, particularly public sector schemes, promise full inflation protection.

Part of the pension can be given up to provide a tax free lump sum. Again, maximum tax free cash is commonly only available after the completion of 40 years service, but in some cases can be available after 20 years. In public sector schemes the lump sum is usually given as a separate item, rather than by giving up part of pension entitlement.

Entitlements to benefits are given at a ‘normal retirement age’, most commonly age 65. Early retirement can be available from age 50 (increasing to age 55 from 2010). Normally early retirement pensions are reduced because they are payable for a longer period and so more expensive for the scheme to fund. Some schemes do allow preferential early retirement pensions, e.g. depending on a formula based on salary and service, or in the event of illness, incapacity or redundancy, which can be a very valuable feature of the scheme. Schemes may also allow increased pensions for retirement after normal retirement age.

Some schemes give discretionary benefits over and above those promised, most typically in respect of pension increases during retirement. However this will depend on the funding of the scheme and is not guaranteed.

Contracting Out of the State Second Pension (S2P)

In general, contracting out means that, if a Final Salary Scheme meets a certain benefit standard, both employer and employee are excused from paying the full rate of National Insurance Contributions and no further State Earnings Related Pensions Scheme (SERPS) or State Second Pension (S2P) accrues. S2P replaced SERPS from 6 April 2002 and is an additional State pension on top of the basic flat-rate pension. In return for joining a contracted out Final Salary Scheme members receive a guaranteed minimum level of benefits on retirement.

What happens if you die?

In the event of death prior to retirement, schemes usually provide a combination of a tax-free lump sum and a taxable pension for a spouse or dependant. The lump sum is usually expressed as a multiple of salary, e.g. two times salary.

The spouse or dependant’s pension is usually expressed as a percentage of the pension that would have applied had the member worked through to normal retirement age. Some schemes provide pensions to children in addition to the spouse.

In the event of death following retirement, a spouse’s pension is normally payable, commonly at a rate of one half or two thirds of that payable to the member. In addition a lump sum is usually paid if death occurs in the first five years of retirement (equal to the balance of five years pension payments).

Taxation Issues

Employee contributions (if any) are entitled to tax relief at source. Contributions are normally deducted from the salary before tax is applied which means that basic or higher rate tax relief is given automatically.

Employers are able to offset regular pension contributions against corporation tax as an expense of the business. Income (apart from UK Equity Dividends) and gains within the pension funds are exempt from tax.

The lump sum available upon retirement is tax free and any pension payments will be subject to income tax at the member’s highest rate.

The lump sum payable on death is normally not subject to Inheritance Tax.

Additional Contributions

The basic benefits from a Company Pension Scheme may be insufficient to meet the member’s retirement objectives. It is possible to make additional pension contributions to increase pension (rather than some other means of saving), or to retire early by:

• Making additional contributions to the Company Scheme, or
• Setting up a separate individual pension scheme to take the additional contributions.

There are two ways to make additional contributions to a Final Salary Scheme. It may be possible to purchase ‘added years’. These will be calculated on the normal scheme basis e.g. 1/60th or 1/80th. The trustees will give a cost of buying additional years and once purchased the benefit is guaranteed. The final benefit received from purchasing the ‘added years’ will depend upon the member’s remuneration approaching retirement. The other option is to contribute to a ‘money purchase’ Additional Voluntary Contribution (AVC) Scheme. This is a separate pension account to the main scheme and grows through contributions and investment growth. There are no guarantees and the value of the fund upon retirement is used to purchase an annuity income for life.

Alternatively it is possible to take out a separate personal pension which will operate in the same way as a money purchase AVC i.e. The final outcome will depend on the contributions paid in and the performance of the chosen investments within the plan. This will have the advantage of being under your personal control but against this there may be features of the Company AVC which are attractive, e.g. lower charges and preferential terms for converting the accumulated fund into pension income.

In most cases advice should be sought regarding the options for paying additional pension contributions including how these compare with non-pensions savings plans.

Maximum Contributions

Historically there was a maximum employee contribution equal to 15% of earnings but this was removed as from 6th April 2006 and now tax relief can be received on contributions up to the full amount of earnings. So for most people this means that contributions can be fixed in relation to affordability and retirement objectives, with full tax relief given.

The combined total of your pension contributions and those of your employer must not exceed the ‘Annual Allowance’ (see Section 1) but for most people this will not require any restriction. If the limit is exceeded, there is a tax charge on the employee for the excess.

Maximum Benefits

The rules of the pension scheme stipulate the benefit you will receive, e.g. in a ‘sixtieths’ scheme you might be entitled to a pension of two-thirds of your earnings after 40 years service on retirement at age 65, or a reduced amount for earlier retirement. It is a major commitment for an employer to promise guaranteed pensions on this basis and the benefits promised would depend on how much the Company (and you) can afford to pay.

Prior to April 2006 there were various ‘regimes’ of Inland Revenue approval that determined the maximum benefits allowable, e.g. the’ two-thirds’ pension mentioned above. Now, instead, a maximum is placed on the amount of pension funds that can be accumulated without incurring a tax charge, called the Lifetime Allowance (see section 1), which is currently £1.5 million during the 2006/07 tax year.

Benefits are tested against the Lifetime Allowance at the time they are taken. For a final salary scheme the effect is that a tax charge could apply if pensions above £75,000 p.a in current terms (dependent on the options selected) are provided from all sources, (apart from the State pension.) Similarly a tax charge could apply for a tax free cash sum greater than 25% of the Lifetime Allowance, or a lump sum on death in service greater than the full Lifetime Allowance.

The tax charge on excess funds is 55% if taken as a lump sum. It is clearly important to avoid such a charge wherever possible and financial advice should be sought where necessary. If you opt to take the excess in the form of pension income the tax charge is 25%, however, this will also be subject to income tax at your highest rate.

For employees who had accumulated pension assets above the value of the Lifetime Allowance, protection can be sought as described in Section 1.

Leaving Service

Few people remain with the same employer throughout their working lives and on leaving service a decision needs to be made regarding any entitlements accrued under a Company pension scheme. It should also be borne in mind that valuable insurances (particularly on death or disability) may be provided as part of, or in conjunction with, the Company scheme, and these insurances will probably cease on leaving service. A review of additional insurance provisions may also be necessary.

Where an employee leaves an employer’s Final Salary Pension Scheme before normal retirement age, he or she may be able to choose from the following six options:

1. Leave the pension rights where they are. This is then known as a preserved pension and the benefits are increased each year in line with minimum statutory requirements. If the Scheme has a surplus discretionary increases may also be awarded.
2. Transfer to a new employer’s occupational pension scheme where the individual has started work with an employer who offers such a scheme.
3. Transfer to a Personal Pension or Stakeholder Plan.
4. Transfer to a Section 32 policy. This is an individual plan which provides ‘money purchase’ in the same way as a personal pension but, in some cases, can provide different investment and death benefit options where the final salary scheme was contracted out.
5. Take early retirement benefits, normally only where the member is aged at least 50 years. This will increase to age 55 from the year 2010.
6. Where the employee has less than two years qualifying service they can take a refund of personal contributions that had been paid into the scheme, subject to certain deductions. However an entitlement to a full transfer (covering employees’ and Company contributions) is available after 3 months.

As you will appreciate, the decision on which option to take, and whether to transfer is not straightforward. In particular a transfer from a Final Salary Scheme may involve giving up a guaranteed benefit and a decision about whether this course of action is suitable will depend upon your attitude to risk. Also if the benefits in the scheme are ‘protected’ – e.g. giving tax free cash above 25% of the fund for pre April 2006 benefits- then that protection could be lost on transfer. Advice should be taken in all cases.

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