Should I transfer out of a final salary pension scheme?
In recent weeks we have received a raft of enquiries from people asking whether they should transfer out of their final salary pension schemes (or defined benefit schemes, as they are also known). Many of these people are being offered unusually generous terms.
Why is that?
Pension fund actuaries are heavily focused – for good reason – on meeting their liabilities. They want to know how long they think they will be responsible for paying a final salary pension (calculated using longevity tables) and what they need to put aside to fulfil that obligation (largely based on the returns offered by “safe” government bonds).
We are currently seeing some final salary schemes offering transfer values in excess of 40 times the annual pension. This far exceeds the multiples traditionally on offer.
Is that tempting?
Interest rates and government bond yields are very low and have been for some time. We could see bond yields and interest rates everywhere start to turn upwards if the powerful force of “reversion to mean” starts to kick in.
The regulator, the Financial Conduct Authority (FCA) warns that “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”. All ceding schemes insist you show that you have received appropriate independent advice before being allowed to transfer out of a pension with anything more than a cash equivalent transfer value of £30,000. Given the strong views of the regulator and concerns about professional indemnity, advisers are often hesitant to engage in this work.
We agree with the FCA that the default position should be that you remain in the final salary pension scheme. The nature of our client base, however, does mean that we see perhaps more examples than many of cases where there are valid reasons for considering a move.
Below we have tried to outline some of the reasons why someone might switch out of a final salary pension scheme. We have also highlighted some of the pitfalls and benefits. This list is not comprehensive. Each individual must take personal advice. We insist on conducting rigorous analysis of the numbers as well as considering the client’s personal circumstances before suggesting any transfer out of a final salary pension scheme. We will do so only if we are assured that you understand the risks involved and that the arguments are thoroughly compelling.
Why does anyone want to transfer out?
As a result of changes introduced by George Osborne in March 2014, the rules on pensions are far more flexible than ever before.
There are several likely benefits if you stay in a final salary pension scheme:
- You have a guaranteed income for life in retirement.
- It is often index-linked.
- Your spouse may continue to receive half or more of this regular income on your death for the rest of their life. These benefits may even extend to children who are dependent or in full-time education.
- In return for a reduced pension, you are likely to be able to take a proportion of your benefits tax-free as a lump sum.
On the negative side:
- Just as with an annuity, the benefits stop once you and your spouse die. If you both die early then the benefit you have received from the accrued contributions into your pension over a working lifetime could be quite small – subject to any continuing dependant’s benefits, which will also ultimately stop.
- You may have no flexibility in the amount of income you take each year, potentially exposing yourself to high tax bills in retirement.
- Your pension depends on the vitality of your employer. Since the Maxwell pension scandal of the 1990s, the Pension Protection Fund (PPF) has been in place to safeguard those in defined benefit schemes (though for many people it will only meet 90% of the commitments; it also applies its own methodology when calculating pension values and this may leave scheme members further out of pocket). Longevity and bond returns have hit many company pension funds. The PPF estimates that eight of every 10 of the near-6,000 schemes potentially within its remit were in deficit at the end of October 2016. The aggregate total deficit for those schemes was £370 billion.
The attractions of transferring out of a final salary pension scheme may include the following:
- Given the current high transfer values and the way the figures are calculated, the amount you can withdraw in a tax-free lump sum may be significantly higher if you transfer out.
- Any money still in your pension pot when you die can be passed to your beneficiaries – this is particularly attractive for those with ill health and low life expectancy.
- Assuming you transferred your final salary pension into a flexi-access drawdown scheme, this money will pass free of inheritance tax if you die before the age of 75. If you die over 75 your beneficiaries can draw from your pension at their own income tax rate. This makes pensions a valuable IHT planning tool. Many of our clients now draw on their non-tax-wrapped savings first and ISAs second, leaving their pension savings till later in life to help reduce any IHT liabilities on their estate.
- You have greater flexibility on how much you draw in a year, which can help you manage tax liabilities.
- Those who have ample other resources and are earmarking their pension pot for their children and grandchildren might want to opt for a longer-term investment strategy designed to maximise the size of the pot beyond their own lifetimes. Transferring out gives more options in this regard.
- You capitalise the fund and insulate it from the risk of the ceding scheme failing.
- You may not have a spouse, making any widow’s or widower’s benefits potentially irrelevant.
The biggest downside of transferring out – and it is a very big one – is that the onus for managing the assets to deliver the returns you require falls on you (and your investment manager). In other words, the risk of investment failure rests with you rather than with your employer.
Calculating the hurdle rate
When looking at this risk it is helpful to assess the rate of return your pension pot would have to provide after transfer to generate the same return on offer in a final salary pension scheme. Broadly, the higher the multiple available on transfer, the lower the hurdle rate. A 40x transfer gives 60% more capital than a 25x transfer and relatively reduces the transaction risk.
Circumstances in which it is worth considering transferring out of a final salary pension scheme
Given these pros and cons, what sort of circumstances might persuade someone to take on the risks of transferring out? A very low hurdle rate is obviously one, but that is not in itself usually an adequate reason.
Some people have sufficient independent means to ensure that the benefits of transferring out far outweigh the consequences of losing this money later or their investments underperforming. Indeed, they don’t even consider it their money – it is earmarked as a long-term inheritance for their children. The ability to pass it on is the overriding issue.
Some may not be quite so wealthy but might have a spouse in the public sector with a good final salary pension scheme as well. They could therefore feel they can take the risk to secure the unusual benefits currently available.
Those who don’t have a spouse or whose spouse is considerably older than them may feel the spousal benefits have little value to them and are worth giving up.
Others may fear for the quality of the guarantees around these “gold-plated” schemes.
I don’t remember transfer values on pensions ever being so high, and the money on offer is often tempting for those with big salaries. This is not a decision to be taken lightly, and it is essential to understand the risks and take good advice.
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