Final Salary Pension Transfer
Defined Benefit Pension Schemes
Defined benefit (DB) pension schemes are more widely known as 'final salary' or 'career average' pensions and have long been considered the crème-de-la-crème of pensions. They are often described as 'gold plated' because they promise to pay a generous, guaranteed and inflation proofed income for life, based on your final or career average salary upon leaving the pension scheme.
A DB scheme typically offers:
- A generous specified level of pension income payable at a specified date in future, the normal retirement age.
- The option to give up some of the pension in return for a tax free lump sum and a reduced pension income.
- The option to take the pension earlier than the normal retirement age with a reduction applied for each year it is taken before the normal retirement age.
- Once in payment, the pension income is indexed i.e. it increases each year by a measure of inflation.
- In the event of death, the pension scheme will pay a pension to a spouse for the remainder of their lifetime. This is typically 50% of original scheme member's pension.
Despite this, the number of people transferring their benefits out of their DB scheme has rocketed in over the past three years and most notably last year in 2016. In this article we look at some of the reasons why.
High Transfer Values
A cash equivalent transfer value (CETV) is the offer made by a DB scheme to give up the promised pension for a cash sum.
A CETV should represent the capital cost of purchasing the income promised by the DB pension scheme. For instance, if your DB pension scheme is estimated to pay you a pension of £20,000 a year at age 65, increasing by inflation thereafter and with a 50% pension to your spouse in the event of death, the pension scheme calculate how much you would need as a capital lump sum to purchase the same benefits with an annuity at age 65 (An annuity is the private pension version of a DB pension and involves giving an insurance company a lump sum in return for a guaranteed lifetime pension income). The pension scheme would then apply a reduction to the value if you are younger than the normal retirement age. Let's say you are age 55, the pension scheme would apply a reduction because you have the benefit of being able to invest the cash sum and benefit from growth for ten years.
Transfer values have been abnormally and sometimes astonishingly high over the past twelve months, typically at 25-35 times the projected pension at normal retirement age although some have been higher and some have been lower. Clients have seen around a 25% increase in their CETV since the EU referendum vote. For those clients who have monitored theirs over consecutive years we have seen 50% increases.
It's no wonder clients eyes are opened when the transfer values arrive in the post - a lifetime of income payable as a lump sum with a Brexit Bonus.
So why are transfer values so high? Some clients have asked me if the pension scheme is trying to buy them out by offering an enhanced value. There may be some truth in that but historically pension providers would explicitly state they have enhanced the CETV. The real and main reason is due to falling gilt yields (bear with me). Using the above example of a £20,000 a year DB pension: to the pension scheme would invest a sum of money to provide you with that level of income for the rest of your lifetime. Using interest rates as a simple analogy, if they were to put the money in a bank account paying 5% interest, the scheme would need to put £400,000 in the account to generate £20,000 interest. Now if the bank cut the interest rate by half to 2.5%, the scheme would need to double the amount to £800,000 to provide the same level of interest.
In reality, pension schemes invest in a variety of assets with a preference for 'gilts' which are loans to governments and the gilt yields are the interest payments on these loans. The interest rates on gilts have been falling for years and hit historical lows following the EU referendum.
Upon accepting a transfer out of a DB pension, the cash sum is transferred into a private pension fund. Within a private pension fund, the cash can then be accessed from age 55 and spent as you wish; as a single payment, regular payments, ad-hoc withdrawals or left to be drawn when needed. This flexibility to spend a pension fund as you so wish is widely referred to as pension freedoms.
Compared to the fixed pension payable by a DB scheme, this flexibility is preferable to some clients but not all.
The key qualitative factor in considering a transfer for me is what the client wants and by that I mean real needs wants and objectives.
For instance, how do you quantify being able to work less, retire earlier or pursue a lifetime ambition sooner. Under a DB scheme the reduced pension payable on early retirement may mean the pension income is insufficient whereas accepting a transfer gives the member choice over when and how the cash is spent and the ability to take the view they will spend more in early retirement and less in later retirement.
A key part of the analysis is to look at these objectives and see how the DB pension could satisfy them and then if a transfer out could.
A promise is only as good as the person who makes it
I believe people are generally taking a greater interest in their pensions due to the uncertainty in the world and the focus has sharpened with the collapse of BHS and problems of huge employers like Tata Steel (formerly British Steel) in the headlines. As such people have begun to question how secure their 'gold plated' pensions really are.
The UK wide pension scheme deficits are widely reported to be in excess of £1 trillion. I find it difficult to fathom how much a trillion really is but, in essence, UK pension schemes have to find this money to be able to pay the pensions they have promised. In the main the options are:
- The sponsoring employer makes additional contributions to the pension scheme (these can normally found in the trustee reports and scheme accounts)
- The pension scheme reduces the cost of its liabilities for example by moving from final salary to career average, change the normal retirement age, change the index used for index linking from RPI to CPI.
- The pension scheme is closed.
If a pension scheme is unable to meet its obligations it can be placed into The Pension Protection Fund (PPF), the lifeboat scheme for insolvent pension schemes. There has been debate in the IFA community whether the PPF could cope if it had to pay for pension schemes the size of BHS' and Tata Steel's. In December 2016 Andrew McKinnon, chief financial officer for the PPF said ''When we look back at what progress schemes have made over the past decade, it appears many schemes are just treading water... and with the current economic backdrop conditions will remain tough for 2017''.
I don't think it is too farfetched to suggest that government intervention may be required in future to help DB schemes reduce their liabilities and ease the financial burden on employers. How this might materialise is a good question.
Passing on a Legacy
Another key consideration is death benefits. Under a Final Salary pension the death benefits are generally limited to the spouse’s pension (typically half of your normal pension) payable to a married partner only although some final salary schemes will consider payment of the spouse’s pension to a non-married partner. If you are single, your pension dies with you.
Following a transfer out the death benefits can be considerably greater because the whole value of private pension funds (the CETV plus potential future growth) can be passed on as a lump sum to whomever you nominate (tax free on death before 75). This includes spouse, children, grandchildren, nephews and nieces, friends, charities etc.
Consider the case of a Final Salary scheme member who has divorced. The spouse's pension under the Final Salary Pension could be worthless. If the member had opted to transfer out, the death benefit would be the value of the pension pot and this could be passed onto their children.
What about a couple with a DB scheme each? Do they need two spouse's pensions? Would it be better to maximise income?
Knowing where you stand
Ultimately, the decision on whether to transfer out is a complex one and our view remains that it is often in clients' best interests to remain in the scheme and retain their promised pensions. However, we are of the view that each case should be a consideration of all the quantitative aspects and the qualitative issues of the transfer, focused by the needs of the client.
Our message to clients is to know where you stand! Ask us to help you request an up-to-date statement from your pension scheme administrators including a calculation of the cash equivalent transfer value and review it together with us. By requesting the value the pension scheme will guarantee its value for three months in which time you will be able to consider the offer and understand your options with regards to remaining in the scheme versus transferring the cash sum into a personal pension.
Written by Ben Preston APFS, Cert CII (MP), Cert CII (MP), Chartered Financial Planner
28th February 2017.
Ben holds the CII AF4 advanced pension qualifications to be able to advise individuals and families on defined benefit pension schemes and their overall plans for retirement. If you would like to talk with Ben please feel free to contact us on 0161 969 1703