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Pensionable Salary vs Final Pensionable Salary vs Final Remuneration
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Welcome to the sixth in a series of articles designed to introduce readers to some pensions' related topics.
Pensionable Salary vs Final Pensionable Salary vs Final Remuneration
The following discussion looks at approved occupational pension schemes and the differences between:-
- final remuneration,
- pensionable salary (also referred to as pensionable earnings or pensionable pay) and
- final pensionable salary
Although relevant to both defined benefit and defined contribution schemes, this article concentrates on defined benefit schemes.
A pension scheme member may perceive these three definitions to be one and the same but as can be seen below they can be very different.
Final Remuneration
Final Remuneration refers to the maximum amount of earnings which HMRC will permit to be used for the purpose of calculating the maximum allowable benefits under an approved occupational pension scheme. (Post A-Day Final Remuneration may no longer be relevant to Schemes adopting the new regime.)
The HMRC definition of Final Remuneration is the greater of:
- The highest remuneration in the last five years before retirement, where remuneration is the basic pay in the appropriate year and the yearly average over three or more consecutive years for any fluctuating emoluments
and
- The highest three years average remuneration in the last ten years before retirement
Pensionable Salary
Pensionable salary is used within the definition of Final Pensionable Salary when determining benefits, as defined in the rules of the scheme. This is often less than the definition of final remuneration. It is calculated annually.
The actual definition of pensionable salary is defined in the scheme rules and is an important feature of the design of the scheme. In determining the definition many different factors need to be taken into account. We look below at three of these; how the members' pay is calculated, costs and the members' understanding.
Calculation of pay
Firstly, consideration will be given to how the employee's pay is calculated. Pay may vary significantly from one pay date to the next if it comprises of items such as commission, bonuses or overtime. In other cases an employee may only receive a set rate of basic salary that might only change once a year. The definition of pensionable salary may or may not take into account any variable items. Often it is simply the rate of basic salary in force at the scheme anniversary date.
Cost
Cost probably has the greatest influence on defined benefit scheme design.
Employers may prefer to budget for a fixed company contribution at the start of the year. Including bonuses, commission or overtime makes this very difficult. Fluctuating pensionable salaries can also add to administration costs both for the company and for the administrator of the scheme.
Member Understanding
Finally the definition of pensionable salary can become very confusing for members if it is not the same as the salary defined in their contract of employment or as advised at the last pay review or even on their last pay slip.
For example, consider a member where the definition of pensionable salary is basic salary at the scheme anniversary date but the member is paid a basic salary plus overtime on a regular basis. It is important that the member understands that their overtime will not be included in the calculation of their pension benefits; this could be a significant proportion of their take-home pay.
Where scheme members are trying to plan for their retirement taking into account their actual earnings, members may wish to try and make up this shortfall by paying Additional Voluntary Contributions or payments to a personal pension.
Final Pensionable Salary
Final pensionable salary refers to the amount on which the final benefits are calculated in a defined benefit scheme, as defined in the rules of the scheme. This is often less than the definition of final remuneration and can be less than the definition of pensionable salary. It is calculated only when needed to calculate benefits from the scheme; at retirement, death or at date of leaving the scheme, for example.
There are many definitions of final pensionable salary; some common examples are shown below:-
- Pensionable salary in the last twelve months
- Highest average of any three consecutive pensionable salaries in the last ten years
- Highest pensionable salary in the last five years
- Highest pensionable salary in the last three years
The definition of final pensionable salary can offer members some salary protection as they approach retirement. A member may not be in a position to earn as much salary as they near retirement and so using a historic average, for example, protects those earlier years when their pensionable salary might have been higher. It also prevents artificial enhancement of benefits by increasing salaries just before retirement.
Issues for High earners
The main issue for high earners effects members who have joined an occupational pension scheme since 1989. The maximum salary which can be used is determined by the Earnings Cap, currently £105,600 (2005/6). As this Earnings Cap has been increasing in line with the Retail Price Index (RPI) and individuals may have received earnings increases in excess of this, more and more people are being affected by the Earnings Cap. As a consequence, since 1989 there has been a move to retirement planning which takes into account that part of the remuneration above the Earnings Cap using different types of executive pension plans.
NB From 6 April 2006 a whole new tax regime comes into force which removes the Earnings Cap and could change the design of pension benefits, particularly for higher earners.
Summary
As can be seen, the pension benefits provided by an occupational pension scheme can vary significantly depending on the definitions of pensionable salary, and final pensionable salary. These in turn need to take into account the definition of final remuneration. It is vital that pension scheme members correctly understand the definitions used in order to understand the level of benefits they can expect on retirement.
Robert Wakefield, January 2006.