Pension basics (2019) – pension transfers
The decision to transfer from a defined benefit pension scheme in return for a lump sum of cash must be made very carefully, as Tim explains in this short video.
Pension basics (2019) – pension transfers
Deciding whether, or not, to transfer a pension out of a defined benefit (DB) arrangement and into a defined contribution (DC) plan is one of the most important retirement decisions many employees will make. Here’s why and some of the key factors to weigh up.
Increasing numbers of employers want to reduce their exposure to defined benefit (“final salary”) style pension schemes. That’s because the final liability is unknown and has tended to rise over time thanks to a cocktail of low bond yields and rising life expectancy. So, what many have come up with is the idea of making any remaining scheme members a cash offer to give up their protected benefits.
The DB challenge for employers
Whether or not an employer’s pension scheme can afford to meet its future obligations on existing levels of employer contributions, is a function of several factors, including investment returns, inflation and the average longevity of scheme members. All these uncertain variables place risk on an employer since they may be called on to add extra funds to an underfunded scheme at any time, on the advice of its actuaries.
Whilst in theory, a pension fund of this type can be overfunded (excess assets), in reality many are underfunded (excess liabilities). The fact a scheme can move from one to the other creates a cashflow headache for firms that offer, or have offered, this type of pension arrangement.
To reduce its exposure to such variability and risk, a firm may make a cash offer to anyone still in such a scheme. This is a “take it or leave it” deal – a multiple of the income an employee might expect to receive when they start claiming their benefit, paid as a cash lump sum, in return for giving up all such future rights. These offers can be for up to 40 times that projected annual income, which may look pretty tempting on the face of it. However, given that the decision to accept a “cash equivalent transfer” value is irreversible, how do you weigh it up?
Reasons to stay with a DB scheme
The beauty of a defined benefit scheme for many employees is in the name – the future benefit is known and guaranteed. What’s more it may be hard to match in the open market, even with a sizeable cash sum to invest. Get this decision wrong and not only is all the investment risk transferred from employer to employee, but in a worst-case scenario you could run out of money once you stop work.
Reasons to consider transferring
That all said, some people will like the benefits that come with moving to a defined contribution (money purchase) arrangement. These include; the flexibility around both the age at which you start withdrawing money from the fund (usually earlier), and how the money is withdrawn, if indeed it is at all. Then there is the control over the investment process that comes with DC schemes and the potential inheritance tax benefits of being able to pass on pension assets in certain circumstances.
Since no two people who are made this kind of offer will share identical circumstances and aims, in order to make this important decision, several factors will need to be considered together;
- The age and health of the person considering the transfer. For example, someone in relatively poor health may decide that the value of a cash lump sum, which might be passed on to future generations, outweighs a defined benefit income that might only be received for a few years. Equally, someone who is relatively young may relish the thought of being able to invest their own capital more than someone who is closer to stopping work
- The desire for flexibility. This may matter to someone who has other sources of income (from property or part-time work for example) more than it does to someone who is relying totally on a defined benefit income once they stop work
- Risk tolerance. If you are the kind of person who likes certainty, then a transfer may not make much sense. Risk takers, on the other hand, may be keener provided they understand the decision properly and the consequences of getting it wrong
- Dependents and IHT. The inheritability of defined contribution scheme funds can make them attractive where that is a priority. Equally, where it isn’t a scheme member may not want to give up the certainty they already have of a fixed income under any circumstances.
One thing to bear in mind is that the process of weighing up and making a transfer takes time. This is important as once you have transferred there is no going back. Typically, you can expect to go through a number of key steps;
Perhaps the most important tip when it comes to weighing up a pension transfer is to never be rushed on such an important decision. Fortunately the FCA make it compulsory for anyone who is considering a transfer worth over £30,000 to take advice and the resulting process should take some time if it is done properly. Expect to receive a mixture of hard analysis (for example some steers on the rate of investment growth you will need to replicate a defined benefit income) and more holistic opinion, driven by your circumstances and aims. If you are in any doubt about making the decision to accept a cash lump sum in return for your DB pension rights, the FCA suggest you don’t. In other words, if in doubt, stay put.
To find out more
Feel free to email on [email protected] or contact an Adviser to discuss any of the issues raised here in more detail.