Do I want defined benefits – or flexibility?
First published 06 October 2017 • Updated 30 April 2018
If you have a defined benefit pension, you may be offered a very tricky choice. Stay in the scheme, or take a riskier but more flexible option? What’s right for your colleague may not be right for you. Armstrong Watson Financial Planning shows you how to approach this decision.
Defined benefit (DB) pensions might just be today’s hottest talking point in the financial world. For those who hold them, deciding whether to stay in the security of their scheme, or transfer out to access more flexibility, could be the biggest financial decision they will ever take.
Transfers of this type were once very uncommon, but recently Mercer calculated that around £50bn has been paid to 210,000 members of DB pension plans since 2015 (when pension freedom began). Research by Royal London states the typical value of DB pension transfers is now greater than the average price of a house (in the range of £250,000 to £500,000). Typically, the cash sum offered was worth between 25 and 40 times the value of the annual pension given up. Some would find that an offer that is hard to refuse.
How dependable is my pension?
Meanwhile a new report from the Pensions and Lifetime Savings Association (PLSA) casts doubt on the cast-iron security of DB schemes. It estimates that around three million people in DB pension schemes have only a 50 per cent chance of seeing their benefits paid out in full, as the funds supporting the scheme may not be adequate, due to factors such as increased life expectancy and low interest rates. They are arguing for the creation of a new ‘superfund’ to assist employers in coping with growing financial liabilities, and the pooling together of some pension schemes to reduce the burden on certain businesses and lessen the risk for scheme members.
So how do these factors affect the arguments for and against transferring a DB pension?
Guarantees versus flexibility
The holder of a DB pension knows that, from a set future date, they will have a known and guaranteed income for the rest of their life (assuming their scheme does not collapse). So trading in this pension for what is known as a Cash Equivalent Transfer Value (CETV) is not an easy decision. A CETV can be invested in a personal pension with much more flexible access, but will lose those valuable guarantees. So how do you choose?
Depending on your perspective, the current dash for pension cash is either the next high profile miss-selling scandal in the making, or the opportunity for many to take more control of their incomes in retirement. In fact, which of these it is may depend largely on your own circumstances.
The current guidance from the FCA (the regulator) is quite clear: advisers should start from the assumption that a transfer out of a DB scheme is generally unsuitable, and only then consider other factors. But a new consultation paper proposes a different position: that ‘An assessment of suitability should focus on whether a transaction is right for the individual and should be assessed on a case by case basis from a neutral starting position. The adviser needs to demonstrate that the transfer is in the best interests of the client.’
At Armstrong Watson we have received a significant number of enquiries about transferring out of DB schemes. In abiding by the current FCA guidance, we have advised twice as many clients to remain with their current schemes than to transfer away. So when is it right to consider such a transfer?
Here are the main issues that motivate individuals to consider giving up the ‘gold plated’ guarantees within their company pension schemes, in exchange for a CETV.
The ability to control the timing of income and capital extraction is often seen as the ultimate flexibility. DB pension income commences at a fixed age (say 60 or 65) and then simply pays a rising income for life. However, income needs in retirement may not be uniform. Being able to retire sooner and draw more income in the early years, then increase and decrease what is drawn at will, is often seen as more attractive than having a high (and escalating) income at the latter end of retirement.
The level of transfer values is at an all-time high, due to schemes trying to reduce their liabilities. In a number of cases we have seen transfer values rise by around 50% in the last two years. The result can sometimes be a CETV in the region of £1m for a pension that at age 65 would pay £25,000 to £30,000 per annum.
Passing wealth on
The benefits of a DB scheme usually mean an income for life for the member, then a 50 per cent pension for the surviving spouse for life. After that, however, all benefits cease. By contrast, any unspent funds taken in the form of a transfer value can pass on down the generations in a tax efficient manner. The sense that family wealth is being created is often a big motivating factor in considering a DB transfer.
In the event of poor health and the likelihood of a reduced life expectancy, it may be more attractive for a person to take as many benefits as possible earlier on, rather than take an income for a potentially shortened life (which may mean that only a fraction of the underlying value is paid out). A person in this position could also retire earlier (say at 55, when a pension pot becomes accessible), and on death can also pass on any unspent pension pot to their spouse and/or children.
With flexibility comes the ability to be tax efficient. In many cases where we have recommended a transfer, the ability to save tax by careful planning is often preferable to defined benefit pension benefits. These flexibilities can include a higher tax free cash sum following the transfer, the ability to limit pension income to specific income tax bands, and the opportunity to defer and minimise the impact of lifetime allowance (LTA) penalty tax charges.
Having helped a small number of clients transfer away from their DB schemes, we take this responsibility very seriously. We make sure that people understand clearly what is being given up compared to what is being gained, and that a coherent plan is in place to ensure that the transfer value accessed is indeed able to deliver the predicted benefits.
Our view at Armstrong Watson Financial Planning is that for many, DB schemes remain the most appropriate choice for supporting their lifestyle in retirement. We only consider recommending a transfer when it can be clearly demonstrated to be in our client’s best interests.
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