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Examples of pensionable salary
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Employer A
Pays a basic salary of £30,000 p.a., plus a further £8,000 p.a. in bonus/overtime.
For pension purposes, it allows employees’ full earnings to be used as pensionable salary.
So, the full £38,000 is used in calculating pension benefit.
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Employer B
Pays a basic salary of £33,000 p.a., plus a further £15,000 p.a. in bonus/overtime.
For pension purposes, it allows only employees’ basic salary to be used as pensionable salary.
So, only £33,000 is used in calculating pension benefit.
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Sometimes, a scheme’s Rules will define pensionable salary in such a way that it uses an average of certain types of earnings where there is likely to be significant fluctuations.
Example of averaging certain earnings which go towards pensionable salary:
pensionable salary = basic salary + average of the last 3 years bonuses
Final salary schemes
A final salary scheme is a type of defined benefit scheme and will use a formula to calculate your pension benefits using 4 key elements. The formula (and the definitions for each part of it) will be set out in the Scheme Rules.
Because your pensionable salary is used as one part of the formula in order to calculate your pension, a final salary scheme is commonly referred to as ‘salary related’ scheme.
In a final salary scheme your pension is based upon your final pensionable salary in the years immediately before you take your pension. Different schemes use different definitions, so it is the definition of your ‘final pensionable salary’ (or ‘final pensionable earnings’) that is important in this type of scheme.
There are many different types of final salary schemes, each having its own formula to calculate members’ benefits.
Example of a final salary formula:
length of pensionable service x final pensionable salary
accrual rate
Three common examples of final pensionable salary would be:
- your last year’s pensionable salary
- an average of your last 3 years pensionable salary
- an average of the best 3 consecutive years pensionable salary over the 10 years before pension benefits are taken.
It’s a fact of life that most of us slow down a little as we grow older. If you are in a physically or mentally demanding job, will you continue to be able meet these demands? If you change jobs within the same employment, would you earn the same? Will your pensionable salary drop? If so, any decrease in your earnings immediately before you draw your pension benefits could have a significant impact upon your retirement provision from a final salary scheme.
In a final salary schemes, your contributions are usually expressed as a percentage of your pensionable salary, e.g. 7% employee with your employer paying the balance of the costs to fund the promised pensions (with the exception of some Public Sector schemes).
Career average revalued earning schemes (CARE schemes)
A CARE scheme is a type of defined benefit scheme and it too uses a formula to calculate your pension benefits using 4 key elements. The formula (and the definitions for each part of it) will be set out in the Scheme Rules.
In a CARE scheme, usually each year’s pensionable salary is revalued (increased) to allow for inflation between the date it was received and the date on which benefits become payable (called inflation adjustment). The total of your pensionable salary is then averaged out by dividing it by the number of years you were a member of the pension scheme.
Example of a ‘CARE scheme’ formula:
length of pensionable service x averaged pensionable salary
accrual rate
The definition of your pensionable salary is important in this type of scheme.
The ‘inflation adjustment’ could be structured in many ways, but would be based upon one of the Prices Inflation Indexes (such as RPI or CPI) or in a generous scheme on Average Earnings increases.
In a CARE scheme, your contributions are usually expressed as a percentage of your pensionable salary, e.g. 7% employee with your employer paying the balance to fund the promised pensions (with the exception of some Public Sector schemes).
Money purchase schemes
A ‘money purchase scheme’ provides benefits based upon the amount of money that is in YOUR own pension ‘pot’ when benefits are due to be paid.
The amount that will be in your ‘pot’ when benefits arise will depend upon the payments made into your ‘pot’; the investment return achieved on each individual payment to the pot; and any costs which are charged against your growing ‘pot’. The benefits you or your dependents will get from a money purchase scheme will come entirely from your ‘pot’.
The contributions that your employer and YOU make to the money purchase scheme will be based upon your earnings and in this respect your pensionable salary is important. As with other types of employer sponsored schemes, calculating your pensionable salary can be quite complex involving factors such as maximum amounts of your earnings which can be taken into account, or exclusions of certain types of earnings.
In an employer sponsored money purchase scheme, your contributions are usually expressed as a percentage of your pensionable salary, e.g. 5% employee, 7% employer contributions.
Summary & Key Points
When making enquiries about your pension benefit it is very important that you make it clear that you are an active member rather than a preserved member or pensioner member. Active, preserved and pensioner are different classes of membership of a pension scheme and any definitions and paragraphs contained within your Scheme Rules or scheme literature relating to any benefit may differ considerably between these categories.
You need to consider the following items:
- What are your total earnings from your employment?
- What is your pensionable salary? What earnings are included or excluded from your pensionable salary?
- Is your pensionable salary much less than your total earnings? If ‘yes’, will this mean that you will have shortfall in your retirement planning?
- Keep informed. Your scheme may modify benefits and Rules. Legislation may change. Your circumstances may alter.
- Rules differ from scheme to scheme and are wide and varied in content. Don’t assume that what applies to one of your pension schemes will necessarily apply to others that you may have.
- HMRC impose rules which registered pension schemes must conform to.
People seldom have identical pensions and you should avoid drawing comparisons with colleagues whose circumstances may at first appear the same but could emerge as having significant differences.
This is not an authoritative document. Seek professional advice from an appropriately experienced and qualified adviser.
What earnings are used in calculating my pension v3.0 Active
Last updated 16/01/2007
