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)
- final pensionable salary
Although relevant to both defined benefit (DB) and defined contribution (DC) schemes, this article concentrates on DB 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.
Until the 'A-day' changes in 2006, Final Remuneration referred to the maximum amount of earnings which HMRC permit to be used for the purpose of calculating maximum allowable benefits under an approved occupational pension scheme. Since 6 April 2006, schemes have become registered rather than approved and final remuneration is no longer used to extablish maximum benefits. However, following the introduction of the lifetime allowance some schemes have chosen to maintain either in part of or in full the old HMRC limits within their rules.
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
- the highest three years average remuneration in the last ten years before retirement
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 and is usually 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 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.
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 plan.
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
For schemes that still maintain a link to the old pre 2006 HMRC limits then the Earnings Cap may still be an issue for high earners who joined the scheme after 1 June 1989. For these groups of members the Earnings Cap was an upper limit on Final Remuneration for establishing maximum contributions and benefits. The Earnings Cap was last officially published in 2006, however the Government continued to declare a notional figure until April 2010 at which point it had risen to £123,600. Some schemes have since continued to calculate their own ‘Earnings Cap’ based in most cases on the method previously used and incorporated this in their rules.
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 where this still applies. 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.