The case for and against transferring out of your final salary pension
Since April 2015, pension freedoms have changed the retirement landscape by giving those aged 55 and over unfettered access to their defined contribution pension pots, with the first 25% tax-free.
While final salary or defined benefit pensions have traditionally been considered ‘gold-plated’ schemes, some individuals are now thinking the “unthinkable”.
Higher transfer values
Along with the new freedoms, transfer values from defined benefit pension schemes are hitting historic highs due to reductions in gilt yields this year. This is because the low interest rate environment and falling gilt yields increase the cost for scheme sponsors providing the benefits, in turn prompting them to offer improved transfer out values.
Matthew Brown, private client partner of Thomas Miller Investment, said: “Deferred scheme members of traditional final salary pension schemes have been afforded an opportunity to transfer funds to more flexible pension arrangements at more favourable rates.
“Swapping a guaranteed pension income for life for an invested personal pension account won’t be the right decision for many. However, for some, a transfer will make a lot of sense, effectively giving control of what is a significant asset. More often than not it will still be right for the individual to remain in the scheme but there are compelling reasons to at least consider a transfer.”
Below, Brown outlines the reasons for and against transferring out of a final salary pension scheme into a defined contribution scheme, if you’ve yet to start drawing on your pension.
Why you might want to transfer out
Health concerns: It may take 20 years or more to receive the transfer value in equivalent income so if you’re seriously ill or need the cash now, transferring out means you have access to money above your usual income.
Death benefits: Transferred funds are likely to offer much better income to spouses as they will not see income automatically reduced. Generally, with a DB scheme no benefit is left for future generations who can again benefit from transferred funds. See YourMoney.com’s What happens to my pension when I die? for more information.
Full access is available to the fund at any time: For some the ability to choose when to take income can have tax planning benefits.
Inheritance tax planning: For some the fund can be left untouched as a highly efficient inheritance tax vehicle. See YourMoney.com’s Protecting family wealth: 10 tips for cutting inheritance tax.
Tax free cash amounts can be higher: Some DB scheme members may also be entitled to ‘scheme protected tax-free cash’ higher than the standard 25% tax-free amount afforded to DC schemes.
Investment returns: The required investment returns to replicate the guaranteed income foregone have often fallen to acceptable levels as transfer values have increased.
Reasons why you may want to stick with your final salary scheme
Capacity for loss: Members need to consider what would happen if the transferred fund was invested and there was a stock market crash. For many there would not be sufficient time for the investment to recover. It is even worse if a fixed income is being drawn from the fund and it loses value, investments are sold at the bottom of the cycle and never have the chance to recover. If you do not have other secure resources to call on, a transfer is far less likely to be appropriate.
Understanding your lifespan: While the transfer value may be large, it will need to last a long time. We all know people who live into their 90s or older, this could be you or your spouse. Think about the indexed linked income you are giving up for all of those years and ask if the transfer value still seems as generous.
Having the right balance: The best financial plans have a balance between security and flexibility. If you only have one defined benefit scheme and no other overarching reason for transfer, would you be moving to more flexibility than what you actually need? After all, once retired you will not want to go out to work again so it is prudent to ensure that some of your income is secure.
Lifetime Allowance: This is a technical but important point. For Lifetime Allowance purposes a pension is valued at 20 times the retirement income when taken as income from a DB scheme. It is not unusual to see transfer values at 35 times. Therefore a £20,000 per annum pension would be valued at £400,000 if taken from the DB scheme but could be worth upwards of £700,000 if a transfer was taken. The Lifetime Allowance is only £1m and anything above this figure is taxed at 55%. By taking a transfer you could be in a position where you take all of the downside risk but only share in some of the upside due to the tax rules. See YourMoney.com’s How to avoid the lifetime allowance charge for more information.
Brown said that giving up an indexed linked pension is a major decision which is why the government insists advice is taken when the value of your pension is more than £30,000.