Final Salary Schemes (Defined Benefit Schemes)

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. 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.

These contributions must now be made in accordance with the minimum funding requirement 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 (max 1.5 final salary), 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 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 £1.8 million in 2011/12, but this will be reduced to £1.5 million in 2012. In terms of contributions the member is limited to the Annual Allowance which is £50,000 in 2011/12, this was recently reduced heavily in the recent cuts. 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.

Currently for all money purchase schemes the retirement benefits can be taken between the ages 55 of 75. 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 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 regulations and there must be an employers contribution to the scheme, although not an employee contribution.

As like Personal Pensions, this area of planning is a minefield, to ensure you navigate the potential mines, why not let FA help you.

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