Key differences

So, what are the differences, advantages and disadvantages?

Trying to compare the benefits of a Final Salary Scheme with the benefits of a Personal pension is complex. However, we hope we can provide you some insight below.

Security
Ultimately the advantages of a Final Salary scheme are the security and certainty they provide. Generally speaking you know what they will pay and that the benefits will be paid for the rest of your life (and the rest of your spouse’s life). The biggest risk that you face is that you employer goes bust and the scheme doesn’t have enough money to pay all the benefits. Even then the scheme will normally enter the Pension Protection Fund (PPF) which should pay 90% of the benefits promised by the scheme for most members. Obviously it can be worrying to find out that your scheme is underfunded, but it’s important not to have a knee jerk reaction because:

  • The transfer value provided by an underfunded scheme will normally reflect that shortfall; and
  • Entering the PPF is likely to be in the best interests of most members as it is more likely to provide better benefits than a transfer to a personal pension.

In contrast modern personal pensions rarely have any guarantees and all of the risks that the employer of a final salary scheme has in funding their scheme would become risks that you would take on. Risks  such as :

  • The risk that the value of investment does not increase enough, or even falls;
  • The risk that inflation is higher than expected;
  • The risk that Interest rates are too low;
  • The risk that you live longer than expected;
  • The risk you need to take benefits earlier than planned (even before retirement).

For example, in a final salary scheme if the investment returns are lower than needed to pay for the benefits, the employer needs to make up the shortfall. With a Personal pension it is the pensioner that would need to make up the shortfall or accept lower benefits.

Flexibility
So while a Final salary scheme has fewer risks (for the pensioner). Personal pensions offer more flexibility in how and when benefits can be taken. However it is important to remember that it isn’t simply a choice about more flexibility or less flexibility. The security of Final Salary schemes come with limited options on when and how to take benefits; and the flexibility of when and how to take benefits in a personal pension comes with loss of security and acceptance of investment and risks.

As above, comparing final salary and personal pensions is a complex affair, but in the table below we have tried to compare, side-by-side, the typical options available in both types of scheme. The benefits of final salary schemes can vary as can an individual member’s entitlement and you must make sure you understand your specific scheme rules and entitlement before making a decision on whether to transfer.

The information in the following table is based on our understanding of current pension legislation, rules and regulations, and current rates of taxation, relief and allowances which are all subject to change.

Tax treatment depends on your individual circumstances.

Final Salary

Personal Pension

Early retirement

Legally you will not be able to take benefits before Age 55 (except through ill health). However, if you retire before the Scheme Retirement Age, you will likely need the permission of the scheme, and your benefits will normally be reduced depending on how early you retire – 4% reduction for every year early is common (e.g. retiring 5 years early would result in a 20% reduction in benefits).

Early retirement

You can take benefits from a personal pension at any time from age 55. The benefits depend on the fund size and the cost of providing an income. While benefits are not reduced, taking benefits before your normal retirement age will mean the fund has had less time to grow, meaning that it will normally be less valuable than it could have been if you retired later.

Late retirement

Most schemes will allow you to delay taking benefits until after the Scheme Retirement Age. Many schemes will increase benefits if you delay retirement – the longer you wait the larger the increase and you would need to confirm that with the scheme before deciding whether to delay retirement.

Late retirement

Can delay talking benefits indefinitely. The benefits you take will depend on the fund value at the time. Subject to actual investment performance waiting to take benefits will mean more time invested and a potentially larger fund than if you had taken benefits earlier.

Flexible retirement

When you retire (whether that’s early or late) you will take the full benefits from the scheme. For example, You will not be allowed to take half of the benefits and delay taking the other half.

Flexible retirement

The Pension freedoms mean that you will be able to take some or all of your tax free cash and delay taking an income. You can secure an income with an annuity or take income from the fund. If you take income from the fund you can start taking an income at any time from age 55 and:

  • Stop taking/restart taking an income whenever you want;
  • Vary the income you take (subject to maximum levels – withdrawals in excess of the maximum amount are treated as ‘lump sums’).

Ill heath retirement

Most Final salary schemes will allow you to take benefits before age 55 if you have to stop work through ill-health or disability. Practice varies between schemes as to whether a reduction in benefits is applied for taking ill-health retirement.

Ill heath retirement

You may be able to take benefits from the Pension before Age 55 if you have serious ill-health or disability. You would need to apply to the pension provider and if eligible you could start taking benefits early. The benefits will depend on the size of your fund and the whether you buy an annuity or not.

Terminal Illness – In cases of terminal illness you may be eligible to take the whole fund tax free.

Death Benefits

(deferred Member)

If you die before retirement, but after you have stopped being an active member of the scheme the lump sum death benefits are typically limited to a return of the contributions you have made to the scheme (but not any contributions the employer made on your behalf), and sometimes with a payment of interest.

If you are married or have dependent children the scheme will pay a pension to them. Most schemes will pay surviving spouses 50% of the pension that the member would have been entitled to, but some schemes will pay more (66% is not uncommon) depending on scheme rules. Some schemes will pay a dependents pension in addition to spouse’s pension.

Any pension will be fully taxable on the spouse or dependent.

Death Benefits

(Before taking pension/lump sum)

If you die before taking any benefits from the scheme the fund value will be paid to your nominated beneficiaries (subject to the desertion of the trustees/administrator as a lump sum or as a successor or nominee pension fund)

Should death be before age 75 payments will be free of income tax. After age 75 payment will be taxable on the beneficiary.

Tax Free Cash (a.k.a. Pension Commencement Lump Sum)

When you take benefits from a Final Salary scheme you will have the opportunity to take a lump sum free of tax. Generally, if members want to take a lump sum they need to give up (commute) some of their income in order to get a lump sum.

The amount of income given up will depend in the scheme rules at the time and the investment conditions and varies between schemes. 

Income is taxed at your marginal rate.

Free Cash (a.k.a. Pension Commencement Lump Sum)

When you take benefits from a personal pension you can take up to 25% of the fund value as a tax free lump sum. After that any other benefit, whether withdrawals directly from the plan, or income via an annuity, will be taxed at your marginal rate

Death benefits (After you have started to take benefits from the scheme)

Death at any age

If you die after you have started taking your pension benefits, the death benefits will normally be limited to pension paid to any surviving spouse (if you were married to them when you retired) or dependents. Most schemes will pay surviving spouses 50% of the pension that you had been receiving, but some schemes will pay more (66% is not uncommon) depending on scheme rules. Some schemes will pay a dependents pension to eligible dependents in addition to spouse’s pension.

This income is chargeable to income tax on the recipient at their marginal rate.

Death benefits (After you have started to take benefit from the pension)

Death before age 75

If you used your fund to by an Annuity, then the benefits will depend on whether you selected an annuity with spouses/dependents benefits. If you did not then your beneficiaries will receive nothing.

If you have been taking an income directly from the pension (income drawdown) the death benefits will be the value of the fund at the time of your death. Your beneficiaries will have the following options which will be free of tax:

  • to buy an annuity,
  • take an income from the fund or to take the benefits as a lump sum.

Death after the age of 75

If you used your fund to by an Annuity, then the benefits will depend on whether you selected an annuity with spouses/dependents benefits. If you did not then your beneficiaries will receive nothing.

If you have been taking an income directly from the pension (income drawdown) the death benefits will be the value of the fund at the time of your death. Your beneficiaries will have the following options – all of these benefits will be taxed at the beneficiaries marginal Income tax rate:

  • to buy an annuity,
  • take an income from the fund or to take the benefits as a lump sum.

Transferring out of a Final Salary scheme is unlikely to be in the best interests of most people.