At retirement a scheme member can choose whether they want a defined income where the pension income is certain but unchangeable or a flexible income. A flexible income can change by choice or fall due to higher risk that reduces the pension fund value. A final salary pension offers the member a secure income that will increase with inflation. Part of this income from a final salary pension can be commuted to a tax free lump sum and this could give the member a flexible income element. This member could opt for a pension transfer to a personal pension if they wanted more flexibility, but of course with more risk. For a money purchase scheme the member could defer taking a defined income as a compulsory purchase annuity and opt for pension drawdown or phased retirement especially if they are phasing in their retirement. There are many choices for the member on retirement and before selecting a pension annuity, they must seek an annuity and pension bureau offering the specialist advice of an independent financial adviser (IFA) that has the qualification K10 (retirement options).               • final salary pension • life annuity     • pension annuity

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Final salary pension
This is an employers pension scheme where the rules specify that the pension income is paid to the scheme member at the normal pension age (NPA) as a defined benefit of the final salary and legislation limits the maximum benefit to 2/3rds of final salary for joiners after 1 June 1989. Both the employer and the member can finance the scheme to meet the benefit obligations in the future from the contributions made, and this is known as a contributory scheme. The retirement benefits can be taken as an income only or a reduced income and commutation to a tax free lump sum.

For some schemes the employer does not require the member to contribute and this is called a non contributory scheme. The employer will however fund the pension scheme from their own resources and the benefits to the member at retirement are defined as a proportion of the final salary. This proportion is calculated as an accrual rate and expressed as a fraction. Most final salary schemes have a 1/60th accrual rate although an employer can offer the employee enhanced rates such as 1/45th or 1/30th. These different rates will determine how quickly the scheme member can build up benefits before retirement.

For example, with a 1/60th scheme to achieve the maximum 2/3rds allowable the member will have to work for 40 years, or 40/60ths. In a 1/45th of 1/30th scheme to achieve the 2/3rds maximum the member will only have to work 30 and 20 years respectively. In retirement the pension income will be protected against inflation. The guaranteed minimum pension (GMP) earned before April 1988 are increased by the retail price index (RPI) by the Department of Social Security (DSS). GMP earned between April 1988 and April 1997 are increased by the employers pension scheme up to the first 3.0% of RPI and by the DSS thereafter.

From April 1997 the Social Security Act 1990 introduced limited price indexation (LPI) to all pension income increasing by the RPI up to a 5.0% per annum cap, and this being payable in whole by the employers scheme. For the member a commutation to a tax free lump sum is also possible and this means that for every year of pensionable service the member will be given 3/80ths towards the lump sum.

So, for a maximum 2/3rds of final salary pension income the scheme member of a 1/60th scheme can have 40 years of service or 120/80ths or one-and-a-half times pensionable earnings paid as a tax free lump sum. If the calculation provides a greater lump sum the member can take up to two-and-a-half times the full initial pension before commutation.

The definition of final remuneration will be determined by the scheme rules and this in turn will influence the members pension income and tax free lump sum. This could simply be the scheme members basic salary or full pensionable earnings based on pay as you earn (PAYE) income. The Pension Schemes Office (PSO) applies its own definitions that can be used by employers.

For the employer to be in a position to pay the benefits in a defined benefit scheme, the employer must comply with the minimum funding requirement (MFR) that will, if attained, ensure that were the scheme discontinued it would have sufficient assets to secure all pensions in payment as well as pay transfer values in the form of a cash equivalent transfer value (CETV) for all those members not yet in receipt of a pension income.

At the normal retirement age (NRA) the member will have the option for a deferred pension if the income is not needed, take a pension income only, take a pension income and commute to a tax free lump sum or select a pension transfer to a money purchase scheme such as a personal pension for a more flexible income arrangement. In the event of the death of the member the scheme rules will indicate the extent of survivors' pension rights but this will usually be expressed as a fraction of the members final salary.

Pension annuity
Unlike final salary schemes where the benefits are defined by the employers pension scheme, an employer's money purchase scheme accumulates a pension fund for each employee via an life company. At retirement the employer can accept the life company's compulsory purchase annuity (or pension annuity) that will guarantee the pension income. By purchasing an annuity the individual will participate in the mortality profit that is partly distributed by providers to annuitants. A private pension scheme such as a personal pension or stakeholder pension will have a pension fund value where the proceeds must be used to purchase the annuity.

Introduced in the Finance Act 1978, modern pensions will also offer the member an open market option. The open market option allows the member to transfer their pension fund from one Life Assurance company to another to achieve a higher annuity rate. The member must exercise an open market option before any benefits are drawn from the existing Life Assurance company in the form of an income or lump sum. Subsequent to exercising an open market option the member must apply the transferred funds to a compulsory purchase annuity.

A maturing defined contribution pension fund can initially withdraw a proportion of this fund up to a maximum of 25.0% as a tax free lump sum, however the balance must be applied to a pension annuity to provide a pension income for the life of the annuitant. Usually under the terms of the pension, the Trustees for the benefit of the annuitant purchase this annuity. The annuity can be written as a joint life annuity and therefore provide the surviving spouse with an income for life or survivors pension. The value of this income can only be determined at the outset but is typically half or 2/3rds of the original annuity.

The resulting pension for the member and eventually the surviving spouse is considered by the Inland Revenue to be relevant earnings and will be taxed as earned income. The amount of pension income will be influenced by;

Where an individual is suffering from a critical illness, an impaired life annuity will enhance the pension income if underwriting can expect a detrimental impact on life expectancy of the individual compared to the mortality tables.

Life annuity
A scheme member could create more pension income at retirement age by applying their commuted tax free lump sum to a purchased life annuity. This is an annuity purchased by a private individual with a lump sum usually ceasing on the death of the annuitant, although it is possible to protect the original lump sum by adding capital protection.

Under section 656 of the Income and Corporation Taxes Act 1988 (ICTA) part of the income is regarded as a return of capital that is free of tax but the interest element will be taxable. This annuity taxation can be compared to a compulsory purchase annuity for a pension where all the income is taxed as earned income.   Bookmark with: What are these?