Final salary pension

The term final salary is used to describe the employers pension scheme that offers a predetermined level of pension benefit and is also known as a defined benefit scheme. The benefits are expressed as a fraction of the final salary for every complete year worked for the company or as a scheme member of the final salary pension. The cost of providing this scheme cannot be accurately determined and therefore although the benefits can be defined, the contributions will need to be reviewed by the scheme trustees and adjusted accordingly.

In 2014 Budget the Chancellor introduced new allowance limits from 27 March and 6 April 2014 and a radical pension change from April 2015 where people are no longer required to purchase annuities. Instead they can now take their 25% tax free lump sum and the remainder of the fund as a cash sum less tax at their marginal rate and this applies to final salary pension transfers.

These contributions must now be made in accordance with the statutory funding objective from 30 December 2005 (formally the minimum funding requirement or MFR) to ensure final salary schemes are adequately funded. For joiners after 1 June 1989 the maximum pension from a final salary scheme is 2/3rds final remuneration requiring a minimum of twenty years service, subject to the earnings cap. This means the fraction cannot be less than 1/30th for each year of service with most companies offering 1/60th schemes requiring 40 years of service to achieve the maximum pensions in retirement.

The member will also have the possibility for commutation to a tax free lump sum and this will be based on the formula of 3/80ths for each year of service times the total number of years of pensionable service, or if a larger sum is calculated, two-and-a-quarter times the full initial pension income before commutation.

For members leaving early, the accrued benefits in the scheme can be left as a deferred pension as long as the member has been in the scheme for 2 years or more. The member will also have the opportunity for a pension transfer to another scheme.


Occupational money purchase

If an employee contracts out of the state earnings related pension scheme (SERPS) the employer will be able to fund a contracted out money purchase scheme (COMPS) with the National Insurance (NI) rebates. COMPS will provide a pension to the member that is based on the performance of the underlying investments. A contracted in money purchase scheme (CIMPS) is a defined contribution approved occupational pension scheme.

Since Pension Simplification from 6 April 2006 the amount of retirement benefits from a money purchase scheme is limited to the Lifetime Allowance which is a total fund of £1.5 million in 2006/07. In terms of contributions the member is limited to the Annual Allowance which was £215,000 in 2006/07.

However, tax relief on the contributions is limited to the higher of 100% of relevant earnings or where tax relief is given at source, limited to £3,600. There is now no restriction to the earnings cap or to the 15% contribution of pensionable earnings as existed before A-Day.

For all money purchase schemes the retirement benefits can be taken between 50 to 75 years of age. An individual can use the pension fund to buy pension annuities and has the option to search for the highest annuity rates using an open market option. Before making a decision at retirement, learn more about annuities, compare annuity rates and secure a personalised annuity quote offering guaranteed rates. At age 75 the member can purchase an annuity after taking a tax free lump sum of 25% or switch to an Alternatively Secured Pension (ASP) and draw an income.

Previous to A-Day the maximum pension income at retirement age was 2/3rds of final pensionable earnings and the maximum commutation to a tax free lump sum was two-and-a-quarter times the pension income at retirement age or 3/80ths for each year of service times final remuneration up to a maximum of one-and-a-half times final remuneration.

It is possible that a scheme member of a CIMPS that makes contributions significantly below the Inland Revenue maximums will be able at retirement age to commute the whole of the pension fund value to a tax free lump sum. This tax free lump sum could now buy a purchase life annuity that has annuity taxation advantages over a pension annuity. Whereas the pension income pays tax at 22% for basic rate taxpayers, the income from a purchase life annuity is paid as capital and interest of which 2/3rds is capital that is tax free and the 1/3rd interest pays tax at a savings rate of 20%.

A CIMPS scheme must be audited each year to comply with the Occupational Pensions Regulatory Authority (OPRA) regulations and there must be an employers contribution to the scheme, although not an employee contribution.


Group personal pension

Unlike an occupational pension scheme such as a final salary pension or small self administered scheme (SSAS), a group personal pension (GPP) is effectively a series of individual personal pensions provided by a single life insurance company. A GPP will cost a scheme member more to operate than a final salary pension and this cost will be met out of the contributions made. Under the Pensions Act 1995 however, the regulation requirements of the employer by operating a GPP are much less onerous and with lower administration costs than a final salary pension scheme.

Both the employer and the employee can contribute to a group personal pension and these contributions will be limited to the Inland Revenue maxima based on the members age. The employee will pay the contributions net of basic rate tax, after pay-as-you-earn (PAYE) tax has been deducted. Any employer contribution will be made gross to the members personal pension. The employee will decide on contracting out of the SERPS but if they do, the NI contributions will be the same as the contracted in rates.

A GPP is a defined contribution scheme and each member is subject to the lifetime allowance and annual allowance. At retirement age between 50 and 75 the fund can be used to purchase an annuity with the option of a 25% commutation to a tax free lump sum. The group scheme, established by the employer as a GPP or group stakeholder pension, represents a collection of individual policies owned by the member and operated by a provider.

When the member leaves the company all the contributions accrued to that date that include those made by the member and the employer will belong to the member. The contributions can be left in the group scheme or transferred to another provider. At retirement the member is free to purchase annuities using an open market option selecting the highest annuity rate at that time to provide an income. At retirement you can compare annuity rates and learn more about the pension annuities available.


Public service scheme

The civil service, armed forces, NHS, teachers, fire services, police and local authorities have access to a public service scheme for retirement benefits and where the scheme rules and regulations are defined by statue. In the case of the principal civil service scheme, there is no direct cost to the scheme member as it is non contributory scheme.

This is in contrast to the NHS pension scheme where scheme members are expected to contribute 6.0% of their pensionable earnings. The accrual rate for public service schemes is a 1/80th of the final salary for each year of service with a maximum pension income of 40/80ths for forty years of service, or half final salary. In addition there will be a non-optional tax free lump sum calculated as 3/80ths of final salary for each year of service with a maximum of 120/80ths for forty years service.

The member can elect for an increase in pension income at retirement age by the commutation of the tax free lump sum. However, the pension income will be taxable as earned income. The pension income and widows pension are subject to limited price indexation (LPI) and payments will rise by the retail price index (RPI) but are capped at 5.0%. In cases of pension sharing section 36 of the Welfare Reform and Pensions Act 1999 (WRPA) allows for indexing benefits. This means that the the former spouse will receive equal terms enjoyed by the scheme member as an integral part of the pension credit.

As statutory schemes are either unfunded or notionally funded, there is no need to comply with the minimum funding requirement as pension benefits are guaranteed by statute, unlike private sector employers pension schemes.

For an unfunded public service scheme the qualifying service will determine a scheme members eligibility to pension benefits. The actual number of years of service usually represents the qualifying service. This can be enhanced with a pension transfer from a previous scheme and extra service credits or added years will also count towards qualifying service for pension benefits.

In addition, the reckonable service will add to a scheme members pension at retirement age. This will include any part-time work, pension transfers from a previous scheme and added years purchased thereby enhancing benefits at retirement age.


Armed Forces Pension Scheme

The Armed Forces Pension Scheme is a final salary, contracted out, unfunded occupational pension scheme and is an exception to other public service schemes being governed by prerogative instruments. These documents are not subject to approval, annulment or amendment by parliament, they derive their authority directly from the Queen.

Under the Naval and Marine Pay and Pensions Act 1865, the prerogative instruments for the Royal Navy and Royal Marines is by an Order of Council, for the Army it is the Pensions Warrant 1977 and for the RAF it is the Queen's Regulations for the Royal Air Force. Unlike private sector companies, the Armed Forces Pension Scheme is designed to meet the special requirements of service life, where youth and fitness are essential elements of the occupation.

This means that the scheme will provide immediate pension benefits to may of the members that leave early and full retirement benefits can be earned by the age of 55. The final value of the retirement benefits will depend on the members years of service and rank, which will determine the members pensionable earnings.