Page last updated at 11:53 GMT, Monday, 17 August 2009 12:53 UK

Q&A: Final salary schemes

A worried man
Final salary schemes have declined in popularity

Considerable debate surrounds the future of final-salary pension schemes for workers in the UK, so here is a brief guide to how they operate.

What are they?

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

They promise 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.

However, Revenue and Customs rules allow members to build up a pension equivalent to two-thirds their final salary.

What are defined benefit schemes?

Final-salary schemes are sometimes called "defined-benefit" schemes.

This is because the benefits are set out by the employer before a member joins the scheme.

Aren't they in trouble?

Final-salary schemes have been big news over the past few years.

This is because a growing number of employers are saying they are too expensive to keep open.

Close to nine million people are still members of UK final-salary schemes.

But the next generation of workers are unlikely to benefit from them, as an increasing number of firms are closing them to new entrants.

Why are they closing?

Stock market falls have meant that the total assets held by many company schemes have shrunk.

If assets fall below liabilities then employers are duty bound to prop up ailing final salary schemes in order to ensure that members are paid their benefits in full.

In a falling market, from an employers perspective, final salary schemes have the potential to become very expensive to run.

The biggest gripe, however, from employers is the 10% tax on dividends earned by pension schemes, which was imposed by the Labour chancellor shortly after the government was elected in 1997.

Dividends play an important part in the long-term health of pension schemes. Any tax on them increases the possibility that the scheme will not have sufficient assets to meet liabilities.

As a result, over recent years, many of the country's biggest employers have abandoned final-salary schemes in favour of cheaper "money purchase schemes".

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