The cost of giving up a final salary pension

Switching from a final salary to a defined contribution workplace pension can cost retirement savers thousands in income.

Employers love defined contribution schemes because they are saving around £1 billion a year in money they would otherwise pay out.

Employees are doing themselves no favours either, as a study by Key retirement benefits suggests they are cutting back on contributions to the tune of £276 million a year as well.

The firm worked out that a worker on average earnings loses almost £2,200 retirement income for every five years they are outside a final salary pension scheme.

In terms of contributions, their pension pots fall £38,000 short of what they would have had in the final salary scheme every five years. That money would have bought the annuity that should have paid the £2,200 income shortfall.

How the schemes differ

Official statistics from the government suggest more than 500,000 workers saving for retirement have moved from a final salary pension into a defined contribution scheme during the past two years.

So what are the differences between the schemes that make the big financial difference?

Final salary schemes offer a guaranteed pension pay out on retirement based on an average salary over a number of years or the final three years of employment.

Defined contribution schemes pay less because they are not guaranteed and the pay out depend on the performance of pension fund investments.

Effectively, on retirement, both pensions can pay up to a 25% tax free lump sum and the balance of the defined contribution fund is invested in an annuity that pays an income for life.

How much the annuity pays depends on the size of the fund.

Endangered species

Other factors that affect the fund size include how much the employer and employee pay into the schemes.

The average payments into a final salary scheme are 14.2% from the employer and 4.9% from the employee, compared with 6.6% from the employer and 2.2% from the employee for a defined contribution pension.

“Final salary schemes are becoming an endangered species for workplace retirement savers,” said Dean Mirfin, of Key Retirement Solutions.

“The attractions of defined contribution schemes are obvious for employers – they are at least half the cost for many firms. Before switching, employees should consider the benefits they are giving up.”

The current annuity pay out on a £100,000 pension fund is around £5,428 a year, compared with £7,676 in September 2008 when rates were at a five-year high.

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