Retirement is traditionally seen as a time to relax and enjoy the rewards of your lifetime of hard work. It can give you the opportunity to take long holidays abroad, master your hobbies, and spend more quality time with your loved ones.
Your retirement is an important chapter of your life, which is why it’s essential that you have enough pension savings to provide you with the lifestyle you want. If you have a final salary pension and are hoping to access that pension early, read on to find out everything you need to know.
What is a defined benefit pension?
To put it simply, a defined benefit pension scheme is one where you will get a guaranteed annual income. Typically, this is based on the salary you earned at a company and how long you worked for them.
Defined benefit pensions are usually associated with the public sector, such as education or healthcare. That being said, some private-sector employers also offer them, though they are now less common than defined contribution pensions schemes.
In these schemes, your employer is responsible for ensuring that there’s enough money to pay you once you reach retirement.
What if my employer can’t pay my final salary pension?
At a time of economic trouble, when many businesses have had to close down due to the coronavirus pandemic, you might be concerned about the prospect of your company going under before or during your retirement. If it does, you may worry about the defined benefit pension schemes you may hold.
Thankfully, if your company gets into financial difficulties and can’t afford to meet its pension obligations, the Pension Protection Fund will cover your guaranteed income.
However, it may be a lower amount than you were promised by your employer.
Knowing that the Pension Protection Fund is there as a safety net in case your employer encounters financial difficulties can give you greater peace of mind if you’re a member of a defined benefit scheme.
What are the pros and cons of a defined benefit pension?
Traditionally, defined benefit pensions (or final salary pensions) been seen as an attractive option. This is because you would need a large defined contribution pension to buy an annuity that would give you the same annual income.
The main advantage of a final salary pension is that it will pay you an income for the rest of your life. It’s easy to see why these schemes are so popular, as having a constant income stream throughout retirement can give you an invaluable sense of security.
Are there any drawbacks to having a final salary pension?
While they have many advantages, there are also some drawbacks to final salary pensions. One of the main ones is that they are often not as flexible as a defined contributions pension would be.
For example, you aren’t able to change the income that you receive from it or take out large lump sums, except for the tax-free lump sum that some schemes offer. There may also be conditions if you want to access your final salary pension early.
How much retirement income might I get from a final salary scheme?
One of the most common ways in which employers can calculate your defined benefit pension income is by basing it off your final salary.
For example, let’s say you’re about to retire and you have been a member of your employer’s final salary scheme for 20 years.
This is where a bit of jargon comes in, which is the “accrual rate”. This is how quickly you build up pension benefits. In this example, we’ll say that your workplace has an accrual rate of 1/60th for each year of your membership in the scheme.
Furthermore, in your final year at the company before you retire, you also have pensionable earnings of £45,000 per year.
To calculate how much income you would receive from your defined benefit pension, you divide your years of work for the company by the accrual rate. Then, you just multiply that number with your earnings in your final year.
So in this example the calculation would be:
- 20 / 60= 1/3
- 1/3 x £45,000 = £15,000
This means that with a final salary pension in this scenario, you would receive £15,000 each year until you pass away.
When can I access my final salary pension?
If you have a final salary pension, the thought of a guaranteed income in retirement may make you wonder how soon you’ll be able to access it. While you can access your State Pension from 66 (in the 2021/22 tax year), you may want to draw income from your pension early.
As you may already know, in 2015 the government implemented Pension Freedoms, which gave people more control over their retirement. One of the main changes that they made was that you can now access a defined contribution pension from the age of 55, rising to 57 by 2028.
With this in mind, you might be asking “Can I take my final salary pension at 55?”
Unfortunately, there is no easy answer to this question as it often depends on the rules of your final salary scheme. If you’re unsure about whether you can access your final salary pension early, then you may want to get in touch with your pension provider.
What is the normal retirement age?
Typically, most final salary pension schemes have a minimum retirement age (sometimes known as a “normal retirement age”) at which you can start to draw your pension and receive your guaranteed income. This normal retirement age tends to vary but is typically between 55 and 65.
It’s also worth noting that with most final salary schemes, your pension provider may give you a reduced annual income if you choose to access your final salary pension early. This simply means you’ll get less income each year than you’d be entitled to if you retired at the scheme’s “normal retirement age”.
If you’re concerned about how this could impact your retirement plans, you may want to seek financial advice.
Can I take a cash lump sum from my final salary pension?
Typically, if you have a final salary pension then you can take a 25% tax-free lump sum (although you’ll have to pay Income Tax on the rest), but this decision may affect your future pension income. This is because taking a lump sum will reduce the amount of annual income that your pension provider will give you.
Due to this fact, it’s important to think carefully about this decision as it could have a significant impact on your retirement plans.
While making a lump sum withdrawal from your final salary pension can help you in the short term, in the long term your decision might affect your financial wellbeing.
For example, if you have a reduced income then you may need to reassess some of your plans for retirement. If this is the case, you may even need to scale back some of your retirement goals.
How large can my tax-free lump sum be?
In most final salary schemes, the amount you can withdraw, and the impact it will have, is determined by the “commutation factor”.
So, for example, if you have a commutation factor of 12 then this means you would give up £1 of income for every £12 of lump sum that you withdraw.
To illustrate this point, let’s say you were retiring with a guaranteed annual income of £15,000 from your final salary scheme. In this example, you are also offered the chance to take a maximum tax-free cash lump sum of £45,000 with a reduced annual pension income.
At your workplace, the cash commutation factor is 12. To work out what effect this would have on you, you need to divide the value of the cash lump sum by 12.
£45,000 / 12 = £3,750
This means your guaranteed pension income would be reduced by £3,750. So, if you chose to take the lump sum, you would only receive £11,250 a year.
What if I need to access my money quickly?
Sometimes, life throws a curveball at you, and you need to access your money quickly. There can be many reasons for this, such as developing an age-related disability and needing to modify your home.
If this happens, you may need a quick injection of cash. Unfortunately, if you’ve already withdrawn your tax-free lump sum, you probably won’t be able to access your wealth quickly.
However, if you need it, one option you could consider is a transfer to a defined contributions pension.
What would a pension transfer mean for me?
If you are in a position where you feel you need an injection of cash, you could consider transferring your defined benefit pension to a defined contribution pension. However, there are some pros and cons to bear in mind.
As we mentioned earlier, this can give you significantly more flexibility with your income and how you manage your pension wealth. This can be useful if you want to withdraw a large amount all at once for a large purchase.
Are there any drawbacks to a final salary pension transfer?
However, one of the main drawbacks to a pension transfer is that you would lose the security of receiving regular payments. This can potentially cause financial worries as you may one day face the nightmare scenario of running out of money.
The income from your final salary pension will keep pace with inflation and will be protected against any economic downturns, unlike a defined contribution pension.
While many millennials are undeterred by volatile markets, for people approaching retirement it may not be wise to take the same risks.
However, if you do decide to transfer out of a final salary pension scheme, the amount you’ll receive in exchange is called the “cash equivalent transfer value”. You’ll also then need to reinvest this money into another pension scheme, which can be a headache.
It’s also important to note that if the benefits from your final salary pension are valued at more than £30,000 then you’ll need to seek financial advice before making a final salary pension transfer.
This is a very big decision, and the Financial Conduct Authority believes that it will be in most people’s best interests to keep their defined benefit pension rather than undertake a transfer. However, the decision is ultimately yours.
Is retiring as soon as I’m able the right decision?
When you’ve reached the normal retirement age for your final salary pension, it’s understandable why you might be tempted by the idea of an early retirement. However, you also need to consider whether it’s the right decision for you.
Retirement is a time that you should be able to relax and enjoy the rewards of your lifetime of hard work and so it’s important to be able to retire with confidence. Even if you have a generous final salary pension scheme, it’s important to ensure that you have enough in retirement so you don’t need to worry about money.
If you want to be able to retire secure in the knowledge that you have enough income for a comfortable and sustainable lifestyle, you may benefit from speaking to a regulated financial adviser. They will be able to establish whether the income provided by any final salary pensions will be sufficient for you to live your desired lifestyle.
How can working with an advisor help me?
When it comes to pensions, there are a lot of factors to consider. It’s also important to ensure that everything is properly sorted, as the last thing you need in retirement is a concern over money.
When you work with a financial advisor, they can help you to get a clear picture of what your finances will look like once you’ve retired. This can help you to make a properly informed decision, enabling you to enjoy your retirement with confidence and security.
Furthermore, final salary pension transfers can be complicated matters, so it’s important to be sure that it’s the right decision for you. If you don’t, you may not have enough pension savings to support your desired lifestyle.
If you think you would benefit from speaking to a financial advisor regarding defined benefit pensions (final salary pensions), use our search tool to find one near you.