Pension: How do pay cuts impact your final salary pension?

Final salary pension schemes are in decline, but according to the Office for National Statistics about 1.3 million people are actively contributing to these scheme and 11.8m have these pensions to claim in the future. But with many workers across the country facing pay cuts as companies struggle amid the coronavirus pandemic, how could a reduction in pay affect these pension schemes?

What is a final salary pension?

A final salary pension scheme, also called a defined benefit pension scheme, is one in which there is a guaranteed payout depending on what you earn when you retire.

Unlike defined contribution (DC) pensions, the amount you’ll get at retirement is guaranteed, and it will be paid directly to you.

This means you will not have to use your pension pot to decide your next move.

How do defined benefit pensions work?

Final salary pensions pay out a secure income for life which increases each year.

Typically you may have a pension with this scheme if you have worked for a large employer or in the public sector.

Your employer contributes to the scheme and is responsible for ensuring there is enough money at the time you retire to pay your pension income.

You can contribute to the scheme too and usually they continue to pay a pension to your spouse, civil partner or dependents when you die.

What is your final salary pension income based on?

Your defined benefit pension income is based on the following factors:

Pensionable service meaning the number of years you have been a member of the scheme.

Pensionable earnings which could be your salary at retirement or your salary average over the course of your career.

Accrual rate which is the proportion of your earnings you will receive as a pension each year in the scheme.

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How to work out your final salary pension

If you have saved into a final salary pension scheme during your career, it will provide you with an income for your retirement based on the above factors.

The pension income is worked out as follows: your years in the scheme, divided by the accrual rate and multiplied by the pensionable earnings.

For instance, if your final salary is £30,000, you worked for your company for 40 years and your company uses an accrual rate of 1/60th, your annual pension would be £20,000.

This figure is calculated by 40 x 1/60th x £30,000.

Will a pay cut impact your final salary pension?

Many workers are finding their pay is being reduced in a bid to avoid redundancies as companies face financial hardship amid the coronavirus pandemic.

For those on defined benefit pension schemes, a pay cut could impact their final salary pension.

In a ‘final salary’ pension scheme, the size of your pension depends on how many years you have been a member of the scheme and on your salary level which means a large pay cut could have an impact.

But it will depend on the exact rules of your scheme.

If you are in a scheme where your pension depends purely on your salary in the year you retire, or perhaps on the final three years, then a big cut in pay now could be very damaging.

If it is calculated as an average over a fixed period it may be more or less impactful depending on the period length.

For instance, if your salary were to fall for the final four years of your working life, your pension could be based on your salary this year and in the last two years.

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