The hidden costs of defined-benefit plans

Many people are happily paying into a pension that they know nothing about, comforted by the idea that they at least have one.

Members of defined-benefit, or final-salary, pension schemes might or might not know that they belong to the best kind of pension scheme available, one that guarantees to pay them a pension based on a proportion of their salary for each year of service. For example, their pension may give them one-sixtieth of their salary for each year of service. If they have been working at the same company for 40 years, they will be on target to receive a pension from their employer two-thirds of their final salary. Or will they?

Many defined-benefit schemes only pay one-eightieth of a salary for each year of service, while most workers these days don't belong to a pension scheme for 40 years, either because they start late, switch from job to job or take career breaks. There will still be plenty of need for members of defined-benefit schemes to sign up to an additional voluntary contribution (AVC) scheme to reach their chosen pension target. But even those with unbroken 40 years' service may find that a large chunk of their pension will be clawed back by their employer under a practice known as integration. Almost 80 per cent of defined-benefit schemes use integration when calculating the final value of the pension they provide, meaning that the practice affects more than 250,000 people.

Under so-called integrated pension schemes, employers adjust employees' pensionable earnings downwards to allow for the fact that they will be eligible for the State pension at 65.

Some employers deduct the value of the annual State pension from the final basic salary before calculating the value of the pension. However, it is more common for employers to deduct one and a half times the value of the State pension.

"Checking with your human resources or accountancy function to see how your pension is calculated will make a huge difference to your pension funding requirements," says James Caron, pensions development manager at Standard Life. Someone earning a basic salary of €60,000 a year may expect to retire on two-thirds of that amount, or €40,000, and still be in line for the State pension, which is currently worth just over €10,000 a year. The bad news is that the employer might subtract 1.5 times €10,000, or €15,000, from the final salary of €60,000, and base the pension on two-thirds of €45,000 (€60,000-€15,000).

This gives a private pension of €30,000. When the State pension of €10,000 is added back on, the retired person's total income is €40,000, or two-thirds of their final salary. But the State pension is not payable until the age of 65, so anyone who retires earlier than this might have to make do with a smaller than expected pension.

"Regardless of which type of integration is used, there is a shortfall which can and bluntly should be bridged," says Caron. Many people in their 30s and upwards are now seriously increasing their AVCs in order to boost their final pension, he says.

Tax relief on pension contributions is an important incentive and is arguably the most valuable tax relief available to PAYE taxpayers, according to Caron.For example, if a higher-rate taxpayer contributes €1,000 a month to a pension through payroll, the after-tax cost is just €520. "That's €480 extra into your pension fund rather than the taxman's coffers," Caron remarks.