Final average salary: Meaning, Criticisms & Real-World Uses

What Is Final Average Salary?

Final average salary refers to a compensation metric primarily used in calculating benefits from a defined benefit plan, a component of pension plan design within the broader category of employee benefits. This metric typically represents the average of an employee's highest earnings over a specified period, usually the last few years of employment, or the highest-earning consecutive years within a longer timeframe. The final average salary is a critical factor in determining the monthly retirement income an individual will receive, linking their highest earning potential to their retirement security. It highlights a core aspect of retirement planning for those covered by such schemes.

History and Origin

The concept of pensions, particularly those structured around defined benefits, has roots in the late 19th and early 20th centuries. Early employer-sponsored plans began appearing with companies like American Express in 1875, followed by railroads, utilities, and manufacturing firms. These initial plans were largely defined benefit plans, promising specific monthly payments to retirees and funded entirely by employers⁸, ⁹. The "final average salary" method gained prominence as a straightforward and seemingly equitable way to calculate these benefits, ensuring that a retiree's pension reflected their peak earning capacity.

Before significant federal regulation, pension promises were often unsecured, leading to instances where workers lost their benefits if a company failed. A notable event was the Studebaker incident in 1963, where thousands of auto workers lost their promised pensions⁷. This spurred legislative action, culminating in the Employee Retirement Income Security Act of 1974 (ERISA). ERISA established minimum standards for private industry pension and health plans, including rules for vesting, funding, and fiduciary duty, thereby solidifying the framework for how final average salary and other pension calculations would be administered and protected⁶.

Key Takeaways

Final average salary is a core component of defined benefit pension calculations, typically based on an employee's highest earnings near retirement.
It provides a predictable and guaranteed income stream in retirement, shifting investment risk management from the employee to the employer.
The specific period for calculating the final average salary (e.g., last 3 or 5 years) and the accrual rate are defined by the pension plan's rules.
Defined benefit plans using final average salary formulas have become less common in the private sector due to increasing costs and longevity risks for employers.
These plans often lack portability, which can affect employees who change jobs frequently.

Formula and Calculation

The calculation for a final average salary pension typically involves three main variables: the final average salary itself, the number of years of service, and an accrual rate (or multiplier) specified by the pension plan.

The general formula is:

\text{Annual Pension Benefit} = \text{Final Average Salary} \times \text{Years of Service} \times \text{Accrual Rate}

Where:

Final Average Salary (FAS): The average of the employee's highest annual salaries over a defined period, such as the last 3 or 5 years of employment. This period is set by the plan and can vary.
Years of Service: The total number of years an employee has participated in the pension plan, as recognized by the employer.
Accrual Rate: A percentage or fraction (e.g., 1.5% or 1/60th) determined by the plan that represents the portion of salary earned as a pension benefit for each year of service. This rate is usually based on actuarial science to ensure the plan's long-term viability.

If the plan specifies a period of 5 years for the final average salary, the calculation would involve summing the five highest annual salaries and dividing by five.

Interpreting the Final Average Salary

The final average salary provides a concrete measure of a retiree's projected pension income. A higher final average salary, combined with a longer service period and a generous accrual rate, translates to a greater annual annuity payment in retirement. This clarity allows employees to anticipate their future financial security, distinguishing defined benefit plans from defined contribution plans where the retirement benefit fluctuates with investment performance. The value derived from the final average salary calculation is often a significant portion of a retiree's income, offering a predictable income floor that is typically not susceptible to market volatility.

Hypothetical Example

Consider an employee, Sarah, who worked for a company offering a defined benefit pension plan. The plan calculates benefits using her final average salary over her last three years of employment, with an accrual rate of 1.75% per year of service. Sarah retired after 30 years of service. Her annual salaries for her last three years were:

Year 1 (last year): $90,000
Year 2: $88,000
Year 3: $87,000

First, calculate her final average salary:

\text{FAS} = \frac{\$90,000 + \$88,000 + \$87,000}{3} = \frac{\$265,000}{3} \approx \$88,333.33

Next, calculate her annual pension benefit:

\text{Annual Pension Benefit} = \$88,333.33 \times 30 \text{ years} \times 0.0175 = \$46,375.00

Based on this calculation, Sarah would receive an annual pension benefit of approximately $46,375.00 for the rest of her life, or she might have the option to take a lump sum payment as permitted by the plan.

Practical Applications

Final average salary schemes are primarily found in the public sector, including government employment (federal, state, and local), and in some legacy private sector unionized industries. These plans are designed to attract and retain experienced personnel by offering a predictable retirement income. For many public employees, their final average salary pension is a cornerstone of their retirement security, complementing other benefits like Social Security.

However, the prevalence of these plans has decreased significantly in the private sector. The shift from defined benefit to defined contribution plans reflects employers' concerns about the financial risks and rising costs associated with guaranteeing a specific benefit, especially given increasing life expectancies and economic inflation ⁵. Despite this, where they still exist, final average salary plans serve as a powerful incentive for long-term employee commitment, reducing turnover and fostering a stable workforce. Historically, these plans were a significant part of the total compensation package, particularly in industries like railroads and banking, where long-term employment was common⁴.

Limitations and Criticisms

Despite their advantages for retirees, final average salary pension plans face several limitations and criticisms. From an employer's perspective, these plans represent a significant financial liability. The obligation to pay a guaranteed benefit, regardless of market performance, exposes the employer to considerable funding risks and requires substantial contributions³. Economic downturns or poor investment returns can lead to underfunded plans, necessitating additional employer contributions or, in severe cases, requiring intervention from entities like the Pension Benefit Guaranty Corporation (PBGC) for private sector plans.

For employees, a major criticism is the lack of portability. Benefits in a final average salary plan are typically tied to continuous service with a single employer. If an employee changes jobs frequently, they may not accrue significant benefits from any single plan, potentially receiving only a reduced vested benefit or no benefit at all from shorter stints of employment. Furthermore, the benefit formula is fixed, limiting an individual's ability to actively increase their retirement income beyond years of service and salary increases, unlike defined contribution plans where employees can often make additional contributions or adjust investment strategies². This can be a drawback for individuals seeking greater control over their retirement savings or those whose career paths involve multiple employers.

Final Average Salary vs. Average Indexed Monthly Earnings

Final average salary and Average Indexed Monthly Earnings (AIME) are both calculations related to retirement income, but they differ significantly in their application and purpose.

Final average salary is a calculation used by private and public sector defined benefit plans to determine an employee's pension benefit. It focuses on an employee's highest earnings, typically over a short period (e.g., 3 to 5 years) just prior to retirement or their highest consecutive years. The intent is to base the pension on the peak earning potential.

In contrast, Average Indexed Monthly Earnings (AIME) is a specific calculation used by the Social Security Administration (SSA) in the United States to determine an individual's Primary Insurance Amount (PIA), which forms the basis of their Social Security benefits. AIME takes into account a worker's entire earnings history (up to 35 years of indexed earnings), adjusting past earnings for national wage growth (indexing) to reflect their value in current dollars, rather than just using raw historical figures¹. This indexing aims to ensure that benefits reflect changes in general wage levels and standards of living over a worker's lifetime. Unlike final average salary, AIME considers a broader span of earnings and specifically adjusts for wage inflation across decades, providing a different perspective on career-long earnings.

FAQs

Q: What is the primary benefit of a final average salary pension for an employee?

A: The primary benefit is a predictable and guaranteed income stream in retirement. Employees know, often years in advance, how their pension benefit will be calculated, providing a strong sense of financial security that is not directly exposed to market fluctuations.

Q: Are final average salary pensions common today?

A: Final average salary pensions, which are a type of defined benefit plan, are less common in the private sector today compared to decades past. However, they remain prevalent in the public sector, such as for government employees and teachers. The trend in the private sector has largely shifted towards defined contribution plans, like 401(k)s.

Q: How does inflation affect a final average salary pension?

A: The final average salary itself is typically based on nominal (unadjusted for inflation) earnings from the period specified by the plan. However, some plans may offer cost-of-living adjustments (COLAs) to the pension benefit once it starts, which can help mitigate the impact of inflation on purchasing power over time. Without such adjustments, the real value of a fixed pension payment can erode due to rising prices.