Final salary pensions: What are they?

Final salary schemes have traditionally been seen as the best type of pension a worker can get.

They guarantee to pay a retirement income based on a percentage of your salary every year for the rest of your life.

The amount you get depends on how long you have spent working for your employer and how much you were earning at the time you gave up work - your final salary.

The sum is typically between a half and a third of your salary.

You may have heard the expression "defined benefit" schemes used alongside final salary pension schemes.

This is merely another phrase used to describe final salary pension schemes.

And money purchase schemes?

Over recent years, some of the country's biggest employers have abandoned "final salary" schemes in favour of money purchase schemes.

'Money purchase' schemes operate very differently.

The crucial difference is that the retirement income a worker can expect to receive is much more uncertain.

This is because the employee must shoulder all the investment risk himself.

In addition, the pension he receives will be determined by the performance of an investment, for example, the stock market.

This is okay if your retirement coincides with a rising market.

However, the market has been falling over recent years, meaning that employees are worse off on retirement.

Stakeholder plans, introduced by the government in April 2001, are a form of Money purchase scheme.

The schemes are known as "defined contribution" plans, for short.

What's an annuity?

If you have a money purchase scheme, you will need to buy an annuity when you want to start drawing your pension.

This effectively "unlocks" the cash to provide an income in retirement.

The amount you get will depend on your age, sex and medical history.

The issue for people retiring now is the annuity rate, which determines the income you will receive for the rest of your life.

The annuity rate - and hence the income - depends on how the market is performing at the time the annuity is purchased.

And in the current stock market climate, many people are having to revise their retirement plans.

So what's the problem?

In summary, these are the main issues facing workers:

• Money purchase schemes: the investment risk is shouldered by the worker, not the employer.
• Reduced contributions: As employers have transferred workers onto money purchase schemes, many employees have also cut the level of contributions.

  This means that not only is their pension income more risky, but they will need to contribute more to achieve the same retirement income as they would under a final salary plan.

• An essential part of pay: Many people view a secure pension as deferred pay. Therefore, if the employer scraps the final salary schemes and contribution levels, it is in effect, a pay cut.

  Should your employment contract guarantee a final salary scheme? Not necessarily. Many do not specify details about the pension.