2nd May 2017
Individuals in defined benefit (DB) pension schemes have the option to transfer to a defined contribution (DC) pension, as long as they have not already started to take income from their pension. This may be attractive for some as DC pensions can be accessed flexibly; meaning that individuals can take income from their pension how and when they want from age 55. This is unlike DB pensions where individuals receive a pre-defined income each year when they retire.
However, transferring from a DB pension scheme can mean that you will be giving up valuable guaranteed benefits and you might find yourself worse off.
Some DB providers have been offering members seemingly generous transfer values to leave the scheme, but is this a good idea?
Please see our checklist of the top 10 things to consider when deciding whether to transfer from a DB to a DC pension scheme;
- Compare transfer value against annual income – The first step is to find out how many years of annual income you would need to match the transfer value offered. This can be achieved by carrying out a calculation which compares the ‘cash equivalent transfer value’ (the lump sum the pension scheme will offer you in exchange for you giving up any future claims to a pension from the scheme) against the ‘current’ annual pension entitlement payable at the scheme’s normal retirement date. For example, if a DB annual income guarantee is £5,000 and the transfer value is £100,000, then the conversion factor would be twenty times (100,000/5,000). There have been some very ‘high’ reported values with reports of forty times the annual income, or even higher. However, it doesn’t mean the transfer value equates to a good deal as by transferring out the member takes on all of the future risk associated with managing the investment and there are other perks, benefits and tax implications to consider.
- Is the paperwork correct? – Transfer value statements often appear to be confusing and it is difficult to work out whether the ‘cash equivalent transfer value’ is high, low, or even correct! Sometimes this is because some organisations quote the pension entitlement at the date the member left the scheme. This could have been many years ago and with deferred pensions benefitting from annual inflationary increases, the actual pension entitlement at the date of the statement could in fact be a lot higher, which would make transferring out less attractive.
- Is the cash really needed? – If you are considering transferring to a DC pension to take all of the income as cash, make sure you understand the tax implications; usually the first 25% of what you take out of a DC pension is tax-free but the remainder is taxed at your ‘marginal’ rate – the rate of income tax you pay when you add all of your sources of income together. If you take the money and simply put it in a bank account it will be subject to inflation risk as the cost of living is likely to increase. That doesn’t mean you shouldn’t transfer and there are good reasons for some people doing so, for example; if you want to pass money on to dependants, prefer the idea of flexibility, or have other significant sources of secure income. But even these are not definitive reasons for doing so and before you give up a guaranteed index-linked income (income that will increase in-line with inflation), you should make sure you know what you will need the money for.
- Don’t forget the ‘perks’ – Most DB schemes have very good benefits. Often they include 50% for a spouse’s/partner’s pension (upon death, either before or after your retirement date), children’s pensions and some offer increases of up to 5% on the deferred pension until the point at which benefits were taken (to help keep the values in-line with inflation), and then provide inflation proofing once in payment. Others also have an element of death benefits in payment if the scheme member passes away within five years of receiving benefits. Some DB scheme members may also be entitled to ‘scheme protected tax-free cash’ higher than the standard 25%. These benefits would be lost in most circumstances if transferred into a DC pension.
- Compare the value against an annuity – Look at what pension fund would be needed in a DC scheme to buy a similar income as those guaranteed by your DB scheme. For example*, a pension transfer value of £30,000 offered in lieu of an income of £1,500 would actually cost £68,000 to buy an annuity for the same rates and perks as outlined above. This is subject to needing a joint life annuity paying for a spouse’s pension, taking it from age 60 and including indexation, which is an expensive addition to any annuity.
- Is a partial transfer available? – Some schemes have started to offer partial transfers to their members. This means that individuals are able to transfer part of their DB pension into a DC pension so that they can access the money flexibly, whilst having the security of keeping the remainder of it in the DB scheme. Partial transfers could be a good option and middle ground for those torn between sticking with a guaranteed income and transferring all of their benefits. It isn’t common yet, but you should check with your scheme to see if they allow it.
- Transferring pensions due to divorce – Pensions can be included as assets in divorce financial settlements. There are several options that couples can take when thinking about splitting their DB pension assets during a divorce. One of these is to transfer the DB pension into a DC scheme so that the income can be fully accessed and split between the two parties. It is important for couples to take specialist advice about this before making any decisions.
- Have you ever contracted-out? – Employees who were contracted out of the ‘State Earnings-Related Pension Scheme’ (SERPS) between 6 April 1978 and 5 April 1997 should check the Guaranteed Minimum Pension (GMP) value (the minimum pension value which an occupational pension scheme has to provide) if they are considering a pension transfer. The amount is said to be ‘broadly equivalent’ to the amount the member would have received had they not been contracted out. Make sure you understand the current value of the income being offered as often it will be quoted at the date you left the scheme and not the uprated value you would get at the scheme retirement date.
- Will the scheme pay out? – Some individuals are worried whether their scheme is secure, and if it will be able to continue to pay out as promised. After all, the scheme is only as good as the company behind it. The PPF (Pension Protection Fund) will generally pay up to 90% of a pension value if the scheme fails, but there is an annual cap of £34,655 (when the 90% level is applied) which may be less than expected.
- Are you equipped to understand your options without advice? – If your DB pension scheme has a transfer value of £30,000 or more, you’ll be required to take financial advice and your Adviser will make a recommendation for you to consider. But if it’s less than this, would you really want to go it alone? Even Advisers find pension transfer documents unclear, full of jargon, and difficult to understand the value of the actual benefits that will be given up. Advisers that specialise in this are required to have specific qualifications and also rely on specialist systems and tools to work out whether the transfer value looks like a good deal. As it’s so complicated and time consuming, it is likely that they will charge for the service whether the transfer goes ahead or not, so it should be something that is carefully considered. But if after weighing up the points above you are confident that you have a good reason to go ahead with a transfer, the value of specialist advice should not be underestimated.
Jonathan Watts-Lay, Director, WEALTH at work, a leading provider of financial education, guidance and advice in the workplace, comments; “In the past the majority of people were better off staying in their DB scheme. It was only worth considering leaving it if someone was seriously ill, or where debt or lack of cash was creating significant life pressure. However recently, there have been some very generous transfer values being offered to leave these schemes. These are difficult to ignore but should be carefully considered, as it’s not going to be a good deal for all. It’s important that you get a good understanding of your own personal situation and take advice from a suitably qualified financial adviser who specialises in this type of transfer before you decide. After all, the average price to fit a new kitchen is £8,000, and very few people would choose to fit it themselves, so why would someone with little or no experience of pensions want to make a decision about a £29,000 pension fund without getting expert advice?”
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