5 April 2017
Last night I attended an interesting event run by the Financial Times. A large group of people came along to learn more about transferring out of Defined Benefit pension schemes.
It was an interesting session. I thought it might be helpful to outline my views on this issue, as the conventional thinking is not necessarily fully reflective of new realities. This is not meant to be giving anybody financial advice, this is about highlighting the important issues that need to be considered, understanding the questions you need to ask and the value of getting financial advice. Whether or not to transfer out of a final salary-type scheme will depend on a complex array of factors that will be personal to each individual. There are some rules of thumb that can be given, but even then it will be best to try to find a financial adviser to help you make sure you’ve considered all the vital issues. I am trying to give a more balanced view here.
There are no absolutely right or wrong answers, but I certainly believe that the current regulatory attitude is out of date. The FCA and the Pensions Regulator both insist that it will almost always be wrong to transfer out. FCA guidance states ‘in most cases you are likely to be worse off if you transfer out of a defined benefit scheme, even if your employer gives you an incentive to leave’. (https://www.fca.org.uk/consumers/pension-transfer) This statement ignores the new realities and complex uncertainties of planning long-term income support in later life.
The benefits of a Defined Benefit pension may not be relevant to some people and, in fact, there are good reasons to consider transferring out. That does not mean it will be right to actually transfer, but particularly with transfer values at such high levels, people may want to at least consider it because there are several potential advantages, particularly after the changes which have made Defined Contribution pensions far more user-friendly, tax efficient and effective for later life planning. In the past, transferring out of a Defined Benefit scheme offered much lower values and people would often need to buy an annuity which represented worse value than their scheme benefits. But in the new DC landscape, people have more flexibility and choice as to how to use their pension fund as best suits their circumstances.
People with a few DB pensions from previous employers, some paying quite small amounts of income, might benefit from transferring thousands of pounds from some of their DB schemes into a DC pension instead. With transfer values having risen significantly, a pension of £20 a week could give £20,000 – £40,000 for a personal pension. Those who are still working and have other secure pension income, could benefit from having the money in a DC scheme which can grow tax free and stay there for them until they are much older, perhaps even to help fund care or be passed on tax-free to loved ones.
Of course, Defined Benefit pensions do have advantages over Defined Contribution arrangements. Here is a list of many of those advantages:
- DB schemes pay lifelong pension income – you can plan your lifestyle without worrying about market falls
- If you live to a ripe old age, your income should still carry on
- Even if the company in charge of your pension scheme fails, you are protected by the Pension Protection Fund (although the level of PPF benefits can fall in future if too many schemes fail)
- You don’t have to worry about what to do with your pension fund or how to get income, those decisions are made for you as the promised income (or PPF benefits) should just be paid to you for life
- You don’t have to worry about investment performance, that is taken care of by others
- Defined Benefit schemes also pay some pension to your spouse if you die first – and some will pay something to dependent children too
- Any pension income that relates to membership of a scheme since 1997 has to have some inflation protection (and some schemes do offer inflation protection before that too)
- Many people had part of their state pension in their final salary-type scheme and this is protected by extremely generous annual uprating every year until you reach pension age (unbelievably generous in many cases)
- Tax treatment for Lifetime allowance is more generous for DB than DC schemes
Why these advantages may not always be as brilliant as some people think
- If you are in poor health, you will not get much out of your employer scheme, whereas with money in a personal pension, you can pass the fund on tax-free
- If you are currently healthy but die soon after reaching pension age, you cannot pass any pension fund on – your pension dies with you as you have no ‘fund’
- If you are single, the spouse’s pension has no value to you
- A spouse’s pension is only a fraction of your full pension, usually half your previous pension
- If your pension relates to an employer you were with before 1997, you may have no inflation protection in your promised pension
- When you draw your pension income, if you are still working you will be taxed on it, possibly at higher rates, whereas if you have the money in a DC fund you can keep it tax free until needed
- Although the pension income should be guaranteed for life, there is a chance that your scheme will fail, and the income you were promised could be cut. This needs to be factored into your decision, especially if the employer sponsoring the scheme is in difficulties.
- If you have a very high level of income from your Defined Benefit pension scheme, it can be severely reduced by the PPF cap.
- PPF benefits could possibly be reduced in future if too many schemes fail (although at the moment the fund has been run very well and is in surplus so this currently seems unlikely.)
Potential advantages of transferring out of a DB scheme into a DC scheme
- If you die relatively young, you can pass on your pension fund to whoever you wish. If you die before age 75, it will pass on free of all tax, whether it is spent now or in future. If you die after age 75, you can pass it on tax free and it stays tax-free until the person who inherits it takes money out.
- Your spouse can inherit your pension fund in full (rather than only a fraction of the income)
- If you have other guaranteed income, you may find a capital sum more useful
- You have ownership of an individual pension fund in your own name instead of an income entitlement that is either fixed, or rises by inflation or a small percentage each year
- You can be in control of your own investments and have a chance to grow your eventual pension
- Transfer values are at record highs, so you will receive a large sum of money if you transfer. For example, a small DB pension worth £500 a year for life, could actually give you a capital sum of £10,000 – £20,000 to put into a DC fund. A DB pension that would pay £20 a week for life, could give you £20,000 – £40,000 capital sum to invest in a DC pension arrangement.
- If you have other pensions elsewhere, (many people have more than one DB pension from past employers), then transferring some smaller pension entitlements can give you a fund that you can invest for future growth, but can also be there to pass on to others or to support you if you become ill or die young.
- If you need money to pay for social care and especially if you have no other savings that could fund such expenditure, then having a pot of money in a tax-free DC pension could be a sensible way to build up a ‘care’ fund. One in four of us is likely to need thousands of pounds for social care in later life, but almost nobody has money set aside for that purpose. Exchanging a small amount of lifelong pension income for a lump sum that can grow over the years to help with care costs can be a sensible choice for some.
- If you need to repay debts or a mortgage, you may benefit from using some of your DB funds even after paying tax – but make sure you get advice on how much tax you’d need to pay
Potential disadvantages of transferring out of a DB scheme into a DC scheme
- You give up a lifelong income stream
- You will have to pay fees on your DC pension fund which might reduce your future pension income
- Your fund may have poor investment performance, so your future income may not be as high as the pension you gave up when you transferred
- You will have to monitor your investments in a DC scheme for future years, whereas the DB pension is looked after by trustees and just paid out to you over regularly over time
- You may find you go over the lifetime limit on DC pensions and have to pay tax – make sure you get advice on your tax position before deciding to transfer out
You really should get financial advice:
If your transfer value is worth over £30,000 you have to have an independent financial adviser to help you, but even for sums below that it is worth considering paying an adviser to help. The decision is individual and will represent a complex balance of risks and potential benefits.
Here are some questions you need to think about and discuss with an adviser before making a decision – and don’t forget, once you’ve transferred out of a DB scheme, the decision is irreversible.
12 of the questions to consider before transferring from DB to DC:
- Is this just one of a number of pensions and I want to cash some in and leave the rest as income?
- Do I have other secure pension income?
- Am I in poor health and not expecting to draw the guaranteed pension income for very long?
- Am I still working and intending to keep on doing so?
- Will I pay higher rate tax on my pension income?
- Do I want to pass pension assets on tax free to the next generation if I don’t need them myself?
- What will I live on for the rest of my life?
- Do I need a guaranteed income for myself or a partner?
- Do I have other monies that could help fund care or might I want to use this?
- Do the DB pensions I have offer inflation protection (not all pensions accrued before 1997 will have inflation linking)
- Am I happy to pay fees and keep investing to grow my fund further in future?
- Do I understand the tax implications of transferring out (BEWARE, this is complex!)
Understand the issues before making any decision about transferring out of a DB scheme. It may be right for you, especially if you’re in poor health, or you have other pensions, or are still working and want to benefit from future investment returns (accepting the risks and costs of course). With current very high transfer values, (driven up by exceptionally low gilt yields following the Bank of England’s policies that have artificially depressed interest rates) many people are thinking about this. There are advantages and disadvantages and a complex array of risks and benefits that you should consider for yourself. Finally, make sure you get financial advice so you understand the tax and cost implications.