Defined Benefit Pensions To transfer or not to transfer?
Appreciating your perspective
To transfer or not to transfer? That is the question facing many employees who have current or legacy final salary pensions. The recent pension freedom opportunities and current economic environment offer a unique moment to consider whether to transfer out of a Defined Benefit pension plan.
be provided by the defined benefit scheme. For example, a defined benefit pension may provide an annual pension of only about 2.5% of the transfer value. In contrast, a transfer value invested in the market could provide a return of 5% or more, all of which may be withdrawn as income.
Many employees have built up a considerable entitlement to a defined benefit pension over their working life. This type of pension undertakes to pay a predetermined portion of an employee’s final salary perpetually in retirement (hence the schemes are often called ‘final salary’ schemes). However, drawing an annual pension is not the only way to benefit from these schemes. With recent changes to taxation and pensions regulations, it may not be the best way either.
Secondly, if the invested funds are carefully managed during retirement it is likely that some of the funds will remain on death. This creates a fund which can be passed on free of inheritance tax. Looking again at the example in the previous paragraph, by limiting withdrawals to the annual return of 5%, the capital may remain undiminished and can be left on death to a beneficiary. This contrasts with a defined benefit scheme which will not leave a fund on death - although a spouse’s pension, typically of 50%, will usually be provided if there is a marriage or civil partnership.
Transferring out of Defined Benefit Pensions It is possible to transfer out of defined benefit pension funds, receiving a lump sum (known as the ‘transfer value’) into a personal pension. The value of the pension as a lump sum is calculated on a prescribed basis which is complicated (it involves revaluing the pension to the expected retirement date, working out the capital value required to buy that income and then adjusting that capital sum to its present day value). In essence the value is closely linked to annuity rates. Because annuity rates are very low at present, the transfer values on offer are higher than in previous years. By transferring out, it is possible to unlock several opportunities. First, annuity rates are low compared to both current and historic market returns. It is possible to invest the lump sum received in the transfer and potentially provide a larger income in retirement than would
Thirdly, by transferring out of a defined benefit scheme, it is possible to access the new pension freedoms. A defined benefit pension provides little flexibility. Once started, it will pay a prescribed amount until death. For some this regularity will be reassuring. However, many will find it restrictive. The pension freedoms mean that pensions can now accommodate changing circumstances and preferences. For example, an individual may wish to semi-retire, undertaking part-time work, before full retirement: this might require gradually increasing pension income. There may be tax planning opportunities, using the tax free cash to supplement income while still working. A common use for a pension lump sum is to pay off a mortgage, providing the security of owning a home outright. These options are possible after transferring out, but not while remaining in a defined benefit scheme.
Bridging the complex
Remaining in a Defined Benefit Pension
Conclusion
However potential advantages of transferring from a defined benefit pension scheme to a defined contribution one need to be assessed against the costs, risks and loss of benefits involved. Future pension income cannot be predicted with any certainty if you transfer to a defined contribution scheme and you give up any benefits you had in the former employer’s scheme. We therefore assess the appropriateness of a transfer with due regard to individual circumstances, capacity for loss and financial objectives.
Now is a good time to review your defined benefit pension scheme. It may be possible to achieve a greater, more flexible income and leave more to your loved ones by transferring out. Please contact Cantab Asset Management on 020 3651 0570 in order to discuss your situation.
Defined Benefit Pension 3 Pros
7 Cons
Predictable income Little investment risk Favourable Lifetime Allowance rules
Poor death benefits Lack of flexibility Risk of schemes failing Poor value for money if you die young
Defined Contribution Pension 3 Pros
7 Cons
Flexibility Access to large capital sum Tax planning opportunities Usually higher tax free lump sum
Investment risk Money may run out if you live longer than expected Less favourable Lifetime Allowance rules
Cantab Asset Management reviews defined benefit pensions and is authorised by the Financial Conduct Authority to conduct defined benefit transfers. Please note that unfunded government pension schemes do not provide transfer values.
Risk Warnings This document has been prepared based on our understanding of current UK law and HM Revenue and Customs practice, both of which may be the subject of change in the future. The investments we advise on will continue to be diversified across different asset classes and markets. This means that in isolation some of the funds will contain more or less risk than you might normally accept. However, when combined with other investments within your portfolio the overall result is designed to match your tolerance to risk. As with all equity-based and bond-based investments, the value and the income can fall as well as rise and you may not get back all the money you invested. The value of overseas securities will be influenced by the rate of exchange which is used to convert these to sterling. This should therefore be viewed as a medium to long-term investment. Past performance is not a guide to the future. Please be aware that if you decide to cancel, and in the meantime the value of your investment has fallen, you may not receive back the full amount you invested. While recommended investment transactions remain pending, including those associated with transfers, investment markets may rise or fall so there is potential for loss of income or growth. For investments in property funds, the value of land or buildings is generally a matter of the valuer’s opinion, rather than fact. You may not be able to encash your investment whenever you choose because the land and buildings in the funds may not always be easy to sell and, during periods when they are not readily saleable, the fund manager may refuse to repurchase or surrender your units. By taking your pension in drawdown you are exposed to market risk in retirement, and your funds may run out before your death. High income withdrawals are likely to erode the capital value of your pension fund and may not be sustainable. This could result in a lower income if an annuity is eventually purchased. You should weigh up the flexibility of withdrawing income against the certainty of buying an annuity which pays you a guaranteed amount for the rest of your life. The fund available to buy an annuity may be lower than illustrated. This could happen for a number of reasons, for example if investment growth is lower than illustrated or charges increase above those shown on the illustration. Any annuity bought in the future will depend on interest rates at that time and the investment performance of your plan. No guarantee can be made that annuity rates will be better at that time. Actuarial research indicates that individuals are living longer and this is predicted to mean that annuity rates will fall in the future and are likely to be less than they are now. If you purchase an annuity you may benefit from a cross subsidy from those annuitants that die relatively early. This cross subsidy is not present with drawdown pension. Therefore a higher investment return will be required to provide a comparable income. This article does not constitute investment advice. For investment advice please consult an investment adviser at Cantab Asset Management. Cantab Asset Management Ltd is authorised and regulated by the Financial Conduct Authority.
Cantab Asset Management Ltd 5th Floor, 8 Angel Court, London EC2R 7HP 020 3651 0570 35 Hills Road, Cambridge CB2 1NT 01223 52 2000 cantabam.com