Will a large pay cut reduce my final salary pension too?

I am nearly 56 years old and have had a final salary pension for more than a decade. The company is proposing a pay cut of 22 per cent.

I was wondering how this will affect my pension pot as I only have another four years of contributions left.

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Steve Webb replies: In a ‘final salary’ pension scheme, the size of your pension depends on how many years you have been a member of the scheme and on your salary level.

A big cut in salary late in life could therefore have an impact on your pension.

However, a lot depends on the exact rules of your scheme and the first thing that you should do is check the scheme rules to find out what salary figure is used to work out your pension.

If you are in a scheme where your pension depends purely on your salary in the year you retire, or perhaps on the final three years, then a big cut in pay now could be very damaging.

Indeed, as I will explain below, there might even be a case for considering opting out of the scheme at this point.

However, precisely in order to avoid big swings in the value of pensions arising from last minute changes in pay, many ‘final salary’ pensions are not based purely on the last few years of your working life.

Another way some schemes work out your ‘final salary’ is to take an average over a three year period, and that could be the best three year period in the ten years before pension age.

In this case, even if your salary were to fall for the final four years of your working life, your pension could be based on your salary this year and in the last two years.

This would provide a measure of insulation against the effects of a large salary cut of the sort that you are faced with.

If your pension is simply based on your final year of pay (or final three years) then your decision is more complicated.

One option would be to opt out of the pension scheme altogether. The reason for doing this is that your ‘final’ salary when the pension was worked out would then be the wage you now earn, before the pay cut.

The advantage is this ‘locks in’ your current salary as the basis for the pension calculation. The downside is that you miss out on four more years of membership of the scheme, including four more years of substantial contributions from your employer.

Clearly, there are not many situations in which it is a good idea to opt out of an open ‘final salary’ pension of this sort.

You should certainly take financial advice if possible before making such a decision. If a number of your colleagues are in the same situation you may be able to get together to get some advice and/or your trade union might be able to help.

I see that you are in your mid-50s and therefore more than a decade away from being able to draw a state pension.

You may want to use that period to build up an additional pension pot to complement the final salary pension that you have already.

If you did opt out of the final salary pension scheme, you should certainly consider joining a ‘pot of money’ type pension arrangement if your employer offers one.

Although this will almost certainly be less generous than the scheme you have left, you would still benefit from an employer contribution and tax relief on your own contributions.