What You Need To Know About Final Salary Defined Benefit Transfers

What You Need To Know About Final Salary Defined Benefit Transfers

This comprehensive guide is designed to give a balanced view on when it may or may not be in your best interest to transfer out from a final salary defined benefit company pension scheme.

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Introduction To Final Salary Defined Benefit Pension Transfers

A good place to start is the Financial Conduct Authority’s page on final salary defined benefit pension transfers which states:

In most cases you are likely to be worse off if you transfer out of a defined benefit scheme, even if your employer gives you an incentive to leave.  The cash value may be less than the value of the defined benefit payments to you and your eventual pension payments will depend on the performance of the new scheme, with the risk that the scheme does not deliver the returns that you expect.

The Financial Conduct Authority website does, however, point out that:

There are risks to staying too.

The World Of Pensions Is Changing

In the past, many people who worked for private firms built up a company pension based on how long they had worked for the firm and how much they earned.  The amount of pension they would get was guaranteed by the rules of the pension scheme, and so they were known as defined benefit pensions, sometimes known as final salary or average salary pensions, the most common of which is a 60th of your final salary or average salary for each year in the scheme.

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Final Salary Defined Benefit Pensions Have Several Advantages

Your pension lasts as long as you do, so there’s no danger of you running out of money.

There is something for a surviving spouse after you die.  The details vary from scheme to scheme, but survivors’ pensions of half of the scheme member’s pension are common.

There is some measure of protection against inflation, which helps to maintain the spending power of your pension.  Again, the exact provision varies from scheme to scheme, but there is a legal minimum which all schemes have to deliver.

Your pension is unaffected by the ups and downs of the stock market.

Despite all these advantages, there are some downsides to having a pension of this sort, such as a lack of choice over when and how to take your pension.  Growing numbers of people are considering whether to exchange their defined benefit pension rights for a cash equivalent.

The purpose of this guide is to provide some basic information about the pros and cons of making a transfer of this sort, so that you are better informed prior to seeking impartial and expert financial advice about your individual circumstances.  However, it is important to stress that, because of the attractive features of defined benefit pensions, the Financial Conduct Authority tells financial advisers to start from the assumption that it is not in people’s interests to exchange their defined benefit pension rights for a cash alternative.

Growing numbers of people are being offered very large cash sums in exchange for giving up all their rights in their defined benefit pension scheme.  These cash sums can be used in two main ways:

1. For those who are still saving for their retirement, the cash sum can be transferred into a personal pension where it will be invested.

2. For those who want to start living off the proceeds of their pension, it can be transferred into a drawdown account, where some of the money is invested, and some is taken out, either in lump sums or as a regular income.

In both cases, there is no guarantee as to the future level of income, and the only thing that is defined is the contribution going in to the scheme.  For this reason, such arrangements are known as defined contribution or contribution schemes, or even money purchase schemes.

Two factors have led to a growing interest in converting defined benefit pension rights into cash lump sums that can be invested in defined contribution pension arrangements.

First, in 2015, new pension freedoms were introduced which give you more choice over what you can do with your defined contribution pension pots.  Instead of having to buy an annuity that would provide you with an income for life, you can now choose to access your pension pot and draw an income from it when you need it.  As part of these reforms, the inheritance tax treatment of money held in defined contribution pension pots was made much more attractive.

Second, the low interest rate environment of recent years has meant that the transfer values being offered in exchange for defined benefit pension rights have soared to record levels.  This mainly reflects the fact that it is now costing defined benefit schemes a lot more to meet the pension promises that they have made.

For all these reasons, interest in defined benefit to defined contribution transfers is increasing, with advisers and schemes reporting growing numbers of scheme members asking for valuations and seeking advice.

There Are A Few Things To Be Aware Of At The Outset

Defined benefit to defined contribution transfers are irrevocable – you cannot change your mind a few months or years later, even if you wish you hadn’t made the transfer.

Once you have started receiving benefits from your defined benefit pension scheme, you cannot then give them all up in return for cash.  However, occasionally a scheme will offer you a deal where some of your pension benefit can be given up in return for a lump sum.

There are some types of defined benefit pension schemes where cash transfers are not possible.  These are mainly public sector schemes such as those for nurses, teachers and civil servants.  The reason for this is that there is no pension ‘fund’.  The pensions of today’s retired workers are paid for out of the contributions of today’s workers and their employers.  These are often referred to as ‘unfunded’ schemes.

The law requires that if you wish to transfer a defined benefit pension pot valued at £30,000 or more, you must seek financial advice before doing so.

The rules on which transfers must be made with advice are slightly more complex than this, but a scheme would be expected to tell a member if advice is required before the transfer of their final salary rights can take place.  The current Financial Conduct Authority rules on final salary defined benefit transfers are set out in Policy Statement PS15/12.

These are valuable pension rights and they should not be given up lightly.  Any decision about what to do with them should be made on an informed basis, and few individual savers would have the necessary expertise to make that judgment.  We strongly support the requirement to take advice before giving up significant defined benefit pension rights.  This advice can also look at the whole of an individual’s pension rights, which may lie in several schemes and be a mixture of defined benefit and defined contribution rights.

This guide is not designed as a substitute for impartial, tailored financial advice.

What this guide does seek to do, however, is simply to help you in the early stages of considering a defined benefit to defined contribution transfer by familiarising you with some of the key issues that you will need to take into consideration.  This will hopefully lead to a more informed conversation with your adviser if you decide to proceed to the next stage.  The guide seeks neither to encourage nor to discourage such final salary transfers, but rather to set out in a balanced way the pros and cons of retaining your defined benefit pension rights as compared with taking a transfer.

Our second purpose is to offer some thoughts on how the process could work better for the public and for those who advise them.  We explain the current regulatory regime around advice on final salary transfers and argue that it needs to be updated considering the new pension freedoms.  We also argue that the current choice between transferring all your pension rights and none of them is too black and white.  We make the case for giving people the option of a partial transfer, leaving some of their rights within their defined benefit scheme and transferring the remainder as a cash sum.  We believe that this could produce better outcomes for some consumers than the current, rather polarised options open to them at present.

The Current System

At present, if you are a deferred member of a defined benefit pension scheme, you have the right to ask the scheme to offer you a cash lump sum in exchange for your entire defined benefit rights.

This right does not apply to members of ‘unfunded’ schemes such as those in the public sector: teachers, nurses, civil servants and others, as there is no ‘fund’ to transfer.

This lump sum is known as a Cash Equivalent Transfer Value, often referred to as a CETV.

If the transfer value is more than £30,000 you are required to seek independent financial advice before deciding whether or not to proceed with the transfer.  This advice must be provided by, or at least checked by, a specially-qualified pension transfer specialist.

In order to provide advice on the suitability or otherwise of the transfer, the adviser must undertake a ‘Transfer Value Analysis’.

The automated system that uses the Financial Conduct Authority’s standard assumptions to evaluate transfer values is known as ‘TVAS’ or the Transfer Value Analysis System.

The central idea here is that the adviser will look at the cash sum that is being transferred, assess how much that sum might grow to by scheme pension age, and calculate the income for life that could be bought with that pension pot.  This can then be compared with the pension that would have been paid had the scheme member remained in the final salary defined benefit pension scheme.

Advisers will often talk about assessing a potential transfer with reference to a critical yield.  The critical yield is the investment return that would be needed on the transferred sum to build up a large enough pot at retirement to buy retirement benefits at least as good as the defined benefit pension given up.

In many cases, to achieve a pension pot large enough to buy an income for life of equal value to the defined benefit pension foregone will require a relatively high rate of return which in turn would imply taking a high degree of investment risk.  Whilst this is not an absolute bar to an adviser recommending a transfer, many advisers would be nervous about recommending a transfer in such a situation.  However, as we discuss later in this guide, this is not the only consideration, or even necessarily the most appropriate one, when deciding whether a transfer would be in your interests.

If an adviser concludes that a transfer is not in your interests, this is not necessarily a barrier to the transfer taking place.  If you are insistent that you wish the transfer to go ahead, some advisers will implement the transfer in any case, stressing that this is not in line with their advice and that you need to accept responsibility for this decision.  Others will simply decline to facilitate the transfer and you will need to go elsewhere.  This is something worth exploring with your adviser before starting the process.

Of course, there is still likely to be a cost for the work that has been done, even if the recommendation is not to transfer.  In this case, if the consumer proceeds on an ‘insistent’ basis, the adviser fee can be deducted from the value of the transfer, or the consumer can pay a fee directly to the adviser.  If the consumer accepts the recommendation, they will have to meet the cost of the advice from their own resources.  The prospect of paying from one’s own pocket may act as a further incentive towards going ahead with the transfer.

In the next two sections, we consider some of the reasons why turning final salary defined benefit pension rights into cash might be a good idea for some, and then some of the reasons why others might be better advised to keep their pension rights where they are.

Good Reasons To Transfer

Flexibility

Whilst defined benefit pension rights can be very valuable and attractive, they can also be rather rigid and inflexible.  For example, a scheme may have a set pension age and although taking an early pension may be possible, it may not be on favourable terms.  In this case, taking your pension earlier may mean it is much lower than if you had waited until you reached pension age.  Similarly, a scheme may have generous arrangements for married members who leave behind a widow or widower, but these may be of no value to unmarried members of the scheme.

If you convert your defined benefit pension rights into cash and put the money into a defined contribution pension instead, then you benefit from the new pension freedoms which allow you much more choice about how you use your money.  In addition, the cash amount that you are offered will generally reflect the average cost to the scheme of providing benefits to widows and widowers, so if you are a single person, you will get some of the value of that provision which you would not have done if you had stayed in the scheme.

Of course, if you are married, the opposite argument would apply.

In terms of flexibility, those aged 55 and over can now generally access their defined contribution pension pot as they wish.  If you wanted to retire at 60 and live off your savings, you could do this with a defined contribution pension, whereas you might have had to wait until you were 65 if you had stayed in the defined benefit scheme.  Transferring the money does not mean it will last any longer (indeed, if the valuation of the rights is done on a cautious basis, you may be losing some value when you transfer).  Although you can take your pension earlier under a defined contribution arrangement, you will be spreading the value of your pot over more years than if you had waited until the scheme pension age under the defined benefit arrangement.

Another important aspect of the increased flexibility following a transfer is that you can decide how you want to spread your income and spending through your retirement, rather than having a rigid amount throughout.  For example, you may take the view that you want to spend more in earlier retirement while you are more mobile and able to travel, and spend less later in retirement, and having a defined contribution pot to draw on enables you to make choices of that sort.

Potential For Access To More Tax-Free Cash

Whilst income from a private pension is subject to income tax, most pensions allow you to take one quarter in the form of tax-free cash.  In a defined benefit pension, this usually means you get a cash lump sum at retirement plus a lower regular pension than if you had not taken the cash.

Some defined benefit schemes are designed by default to give you a lump sum plus a regular pension and may not have the option to take the benefits exclusively as a (larger) regular pension with no lump sum.

In a defined contribution pension, you can generally take one quarter of your pension pot as a tax-free cash lump sum, provided you are aged 55 or over.

One reason why a transfer to a defined contribution arrangement may be attractive is the potential to draw a larger tax-free cash lump sum than if you remained in the defined benefit scheme.

If you stay in a defined benefit arrangement, you can generally give up a quarter of your pension rights in exchange for a tax-free lump sum.  However, the value you get is generally less than a quarter of the value of your pension.  This can be for a number of reasons.  These include the following:

Schemes have varying rules for how the pension you have given up is converted into an equivalent lump sum and in some cases, these can be very ungenerous, especially in today’s low interest rate environment.

The process of converting from a regular pension to a lump sum is based on the scheme member’s pension only, but the rights given up include a potential pension for a widow or widower.

Complex tax rules can mean that the size of the lump sum is reduced relative to the amount of pension given up.

One way of thinking about these rates for converting pension foregone into a lump sum is to think about how long you are likely to live.

A good place to check is the Office for National Statistics website in an article on final salary defined benefit transfers entitled How Long Will My Pension Need To Last.

Suppose you expect to live for 20 years and are giving up a pension of £250 a month, or £3,000 a year.  Over the next 20 years, you would receive £3,000 times 20 years, or £60,000 in pension (excluding the effects of inflation).  So, if the defined benefit scheme offers you a tax-free lump sum of less than £60,000, you might feel that you are not getting a good deal.

An alternative would be to withdraw your entire defined benefit pension rights and transfer them into a defined contribution arrangement.  Once the money is in a defined contribution arrangement (and assuming you are aged 55 or over), you can then take one quarter of the whole pot as a tax-free lump sum, and this is likely to be a larger figure than under the defined benefit arrangement.

If tax-free cash is particularly important to you, there may be some advantages to transferring out, especially if your scheme is one that offers relatively ungenerous tax-free lump sums within the scheme.

Note that the amount of tax-free cash is potentially larger if you immediately take 25 per cent following the transfer.  If you simply put your transfer value into a defined contribution pension some years before retirement, then whether or not you get a larger tax-free lump sum depends on the investment performance of the funds between the transfer and when you take the lump sum.

Inheritance

Whether or not it makes sense to stay in your defined benefit scheme may depend, in part, on who will be left behind after your death, and to what extent you want to support them financially.  Recent changes in the tax rules on inheritance of certain sorts of pensions have made it more attractive to consider having your pension rights outside the existing defined benefit scheme (the Financial Conduct Authority does not regulate estate planning).

If you remain a member of your current final salary pension scheme, then when you die, there may be a pension for your surviving widow or widower.  If you die very early, perhaps a few years into receiving your pension, your widow or widower may benefit from a guarantee period where the full pension has to be paid for a minimum of (say) five years.

If you are part of a couple but not married, those rights may be more limited, but this will vary from scheme to scheme and may be at the discretion of the scheme trustees.  And there may also be some pension entitlement to any surviving dependants, such as children of school age.

Whilst such provision is welcome and valuable, it does mean that in many cases when you, and perhaps your widow/widower, die, your pension dies with you.  In particular, there is nothing left to pass on to your heirs and successors.

An alternative is to convert your defined benefit pension rights into cash and then transfer the money into a pension (if you are still saving) or a drawdown arrangement.  In this case, if you were to die, the value of the assets in the pension or investment could pass on to your heirs.  One particularly important consideration is the tax treatment of such money.  Under recent changes, if you die before the age of 75, then the cash balance left behind can be received by your successors completely tax free.  Even if you die over the age of 75, then whoever inherits your pot only has to pay income tax in the usual way when they make withdrawals.  Furthermore, if your successors do not draw on this inheritance, perhaps because they already have sufficient income, then it can be passed on to subsequent generations.

It is worth noting that if you die within two years of a transfer, your adviser or representatives may be expected to prove that they did not know you were in ‘ill death’.  If they cannot do so, the favourable inheritance tax treatment of the remaining pension pot may be called into question.

Health

One of the advantages of a defined benefit pension is that it lasts as long as you do.

But what about people who think, or know that their life expectancy is likely to be on the short side?  For example, if you draw a pension at 65 and die at 71, then you will not have got much out of the pension scheme compared with someone who lives well into their nineties.  Defined benefit pension schemes work by pooling risk, and in effect those who live for the longest time are subsidised by those who live for the shortest time.

If you think you might be one of those whose life expectancy is below average, then you might consider taking a transfer out.  The value you are offered should (broadly) reflect average life expectancy and this may be a bigger amount of money than the amount it would have cost the scheme to pay your pension if you had stayed in but died relatively young.  If you take your money out in this situation, you could simply invest it with a view to your heirs receiving the cash when you die.  Alternatively, if you are not concerned about leaving anything behind after you are gone, you could buy something called an enhanced annuity.  This is basically an income for life, but one which takes some account of your likelihood of dying prematurely.  So, for example, someone who has been a chain smoker all their life or who has a serious medical condition might be able to get a relatively generous annuity rate because the annuity provider does not expect to be paying the annuity for very long.  One option would be to obtain a transfer value quotation from your current scheme and then find out what annuity you might be able to buy before actually making the transfer.  You could then form a view as to which option would give you the better value.

Concerns About The Solvency Of The Sponsoring Employer

If the employer who sponsors your final salary pension scheme is at risk of becoming insolvent, then there is a chance that you might not get all the pension you were expecting.  But if you transfer out of the scheme, then your investment fund will be unaffected by what subsequently happens to your ex-employer’s business.

The way the system works is that if the firm that stands behind a defined benefit pension scheme becomes insolvent, and if the pension scheme is well short of the money it needs to pay all of its future pension promises, then the scheme will be transferred into an insurance-type lifeboat arrangement called the Pension Protection Fund.

Under the rules of the Pension Protection Fund, those who have already reached the normal age for drawing a pension by the time of the insolvency will get 100 per cent of their pension paid by the Pension Protection Fund, whilst those who are under the scheme’s pension age will get 90 per cent.  Note that what matters is your age relative to the scheme’s pension age, and not whether you have retired.

In addition to the reduction for those under scheme pension age, there are several other reasons why the pension you get from the Pension Protection Fund may be lower than the pension you would have got had the employer remained in business:

The Pension Protection Fund only provides annual inflation protection in respect of years of service since 1997.  This is because this is the minimum required by law, but if your scheme had more generous rules, for example, giving you inflation protection for all your service, then you may get a series of smaller annual increases through your retirement.

The Pension Protection Fund uses the Consumer Prices Index as its measure of inflation when setting pension increases.  Some schemes use the generally higher Retail Prices Index.  Over time, this could make a significant difference to how much pension you get.

For those with the highest pension entitlements, the Pension Protection Fund applies a cap if you enter the Pension Protection Fund below scheme pension age.  The cap in the 2017/18 tax year is £39,006.18 which equates to £35,105.56 when the 90 per cent level is applied.  The cap is reduced further if you started to draw your scheme pension early: ie. before normal scheme pension age.

There are plans to increase the cap on a sliding scale for those who have more than 20 years’ service in the scheme in question.

For all these reasons, if you think that your employer might not still be in business in a few years’ time and might leave the pension fund with a significant shortfall, it might be advantageous to consider moving the cash equivalent value of your current pension rights into a pension fund of your own.

Good Reasons Not To Transfer

Certainty

One great advantage of having a defined benefit pension is that it lasts as long as you do.  If you happen to live longer than average, then it is the scheme that has to find the money for this.

By contrast, if you transfer your defined benefit pension rights into cash and manage it yourself, you are taking on the uncertainty about how long you are going to live.  There is clear evidence that people tend to underestimate how long they will live, so there is a risk that you will run out of money prematurely.

On the other hand, you may be so worried about running out of money that you draw down the money too slowly and do not enjoy the full benefit of your retirement savings.

You could overcome this uncertainty by buying an income for life, known as an annuity, but for various reasons this is very unlikely to be as good as the pension you have just given up in your defined benefit pension scheme.  Indeed, if all you want is a guaranteed income for life, then it is hard to see why you would have left your defined benefit scheme in the first place.

It is more likely that you will go on investing your money and drawing an income from your fund, and the big unknown is how quickly it is safe to withdraw money.

There are, of course, things that you can do to manage this risk.  For example, if you use the services of a financial adviser, they can help you to review your investments and your withdrawal rate and adjust if you are running down your pot too quickly.

Whether you are concerned about running out of money too quickly, or about having to be overly cautious about the rate of withdrawal, it is important to understand that these are not problems you would have if you left your money in your defined benefit scheme.

Inflation

In these days of inflation close to zero, it is easy to forget that over a retirement which could last 20 or 30 years, the value of having an income which has some protection against rising prices could be considerable.

Within your final salary defined benefit scheme, the extent of protection against inflation which you enjoy will depend on the rules of the scheme and on when you were a member of the scheme.

To give an example of the importance of inflation protection, let us assume that inflation runs at 2 per cent a year, that your entire defined benefit pension rights are guaranteed to rise by this much, and that you have a 20 year retirement.  If your starting pension at retirement was £100 a week, it would be £148.59 by the end of your retirement.  Without inflation protection you would still be getting £100 a week – a final pension nearly one third lower.

Clearly the cash transfer value that you are offered will reflect the value of the inflation protection built in to your pension scheme.  But once you have taken the cash, all the inflation risk falls to you.  If, for example, inflation was to reach 4 per cent, then in the defined benefit scheme your pension would rise by at least 2.5 per cent, and possibly more.  So, the real year-on-year fall in the value of your pension would only be around 1.5 per cent.  But with a defined contribution pension pot, a 4 per cent rise in the price of goods represents a 4 per cent fall in your standard of living.

Whilst it is possible to insure against rising prices by, for example, turning your pension pot into an inflation-linked annuity, this is likely to be very poor value compared with the pension that you have given up.  Essentially, a defined benefit pension scheme is able to make much more cost-effective provision against the risks of inflation than an individual can do by buying an index-linked annuity from an insurance company.  Of course, if you invest your contribution pension successfully, you may be able to achieve an above-inflation rate of return, but the protection against inflation is not guaranteed in the way that it is in a defined benefit scheme.

In short, if you are concerned about the potential impact of rising prices over the course of a long retirement, and/or about the uncertainty of whether future inflation will be high or low, then staying in a defined benefit scheme will give you both better inflation protection and greater certainty.

Investment Risk

When you are a member of a defined benefit pension scheme, your money is generally invested in a range of assets.  This could include shares, bonds, property, infrastructure assets, commodities and so forth.  The value of these different assets can, of course, go up or down.  But when you are in a defined benefit pension scheme, the ups and downs of these investments make no difference to the amount of pension you receive.  The scheme still must pay your pension and the employer has to bear the investment risk.  You are, in effect, insulated against the ups and downs of investment.

By contrast, if you take a cash transfer and invest the money yourself, the value of your fund can, and will, go up and down.  This could have a considerable upside: your assets might appreciate considerably.  But there is also a considerable downside risk: that your assets will perform badly, and you will have to live on a much-reduced income.

A key consideration therefore is your attitude to risk.  If pretty much all of your non-state pension rights are in your defined benefit scheme, and you convert all of them to a cash lump sum to be invested, then you are taking a big risk.  You need to consider how you would feel and how you would cope if your investments did badly.

Obviously, there are ways in which you can reduce the risk associated with investing in a defined contribution pension or in a drawdown product.  For example, you could invest in lower risk investments, but the potential returns may be smaller as a result.

There is a different sort of risk associated with having your money in a defined contribution arrangement, namely that the provider may go bust.  In this case, there is a Financial Services Compensation Scheme that can provide assistance up to a cap.

The key point here is that when you transfer out of a defined benefit pension scheme, you are transferring investment risk from your old employer’s shoulders onto your own shoulders.

It is also worth bearing in mind the additional costs that you would face if you manage your own contribution pot, rather than leaving your rights in a defined benefit scheme.  These would include the costs of initial and ongoing advice, as well as product fees and charges.  These costs would not arise if you left your funds in a defined benefit scheme.

Provision For Survivors

Since 1997, defined benefit pension schemes have had a legal duty to provide a pension for a surviving widow or widower if a scheme member dies after reaching scheme pension age.

There are complex rules about survivor benefits for same-sex married couples, cohabiting partners etc. and some schemes will do more than the statutory minimum in such cases.

Many schemes will offer benefits for widows and dependent children beyond the legal minimum.

This is a valuable benefit and should not be disregarded lightly.  There will also be some rights for widows (from 1978) and widowers (from 1988) under the rules around Guaranteed Minimum Pensions which many schemes had to provide.

Of course, any cash offer that is made to a scheme member will, to some extent, reflect the fact that the scheme offers benefits to survivors.  But because not all scheme members will be married or have dependants, the cash value on offer will tend to reflect the average value of such benefits across all scheme members, including those who will get no survivor benefits.  In simple terms therefore, the amount of money you might get to reflect the fact that the defined benefit scheme offered survivor benefits would probably be well short of what you would need to buy equivalent benefits if you were to try to do so as an individual.

It is, of course, possible to turn your pot of money into an income for life, with an income for your surviving partner if you were to die.  But defined benefit pension schemes are generally able to offer benefits of this sort in a more economical way than an individual annuity purchaser is able to.  In addition, depending on your surviving spouse’s circumstances, she or he may prefer the certainty of a pension from a defined benefit scheme, rather than having the responsibility of managing an inherited contribution pension pot.

Taxation

For those with larger pension entitlements, the relatively generous tax treatment of defined benefit pension schemes, compared with defined contribution schemes, is another reason to think carefully before transferring out of a defined benefit scheme (the Financial Conduct Authority does not regulate tax planning).

Under current tax rules (tax year 2017/18), you can build up pension rights worth £1 million over your lifetime.  If you go beyond this, you can face tax penalties.

For contribution schemes, it is largely a matter of comparing the total amount of money in the pot against the £1 million lifetime limit.  For defined benefit schemes, a different (and more generous) process applies.  The amount of pension to be paid is multiplied by 20 and any tax-free lump sum is added in.  The result is then tested against the £1 million threshold.  An example will show that as a result there are situations in which a pension left in a defined benefit scheme could be under the tax limit, but the defined contribution equivalent could be over the limit.

Consider, for example, someone with a defined benefit pension at 65 worth £40,000 a year, and assume they do not take a tax-free lump sum.  Multiplying this by 20 gives a figure of £800,000, which is comfortably within HMRC’s £1 million limit.  Now suppose the member asks for a cash equivalent transfer value.  The low level of interest rates and the terms of the pension might result in a multiplier of 30 being applied and a Cash Equivalent Transfer Value of £1.2 million being offered.  If the transfer goes ahead, the member is now potentially at risk of a tax charge on the £200,000 more than the £1 million limit.  Clearly, in this case, the individual has been offered a very large cash sum and the fact that the transfer would result in a tax charge is not of itself a reason not to go ahead.  But it does mean that if you have a larger value pension pot, you need to be aware that there could be tax consequences of making the switch which need to be considered.

To Transfer Or Not To Transfer?

To reiterate the point that we made in the introduction to this guide, we are neither promoting final salary defined benefit to defined contribution transfers, nor seeking to discourage them.  The Financial Conduct Authority is clear that a sensible starting point is the assumption you are likely to be worse off if you transfer out of a defined benefit scheme.  This presumption should help to ensure that you appreciate the value of what you already have by way of guaranteed pension rights in a defined benefit arrangement.

In saying that, we hope that what this guide has done is make you aware of some of the many factors which have to be considered by each individual when deciding whether or not to trade in defined benefit pension rights for a cash sum.  For some people, the arguments in favour of transferring may be particularly compelling.  Those who want to maximise their tax-free cash, do not expect to live long in retirement, are thinking about how best to pass on unspent pension to their heirs, are willing and able to take on the investment risk associated with their pension and/or are worried that the ex-employer standing behind their pension might not be there in years to come, could all find the current terms on offer to be attractive.

On the other hand, those who value the certainty that a defined benefit pension provides may well wish to stay put.  If they do so, they will know that their pension will last as long as they do, that they have a measure of insulation against inflation, that they are less likely to breach tax relief limits, that they do not need to worry about the ups and downs of the financial markets, and that there will be a pension there for a widow or widower when they are gone.

Ultimately, the decision about whether to transfer should be made after a conversation with a regulated adviser who is either a qualified pension transfer specialist or has their work checked by one.  The adviser can take account of your personal circumstances and preferences.  Whilst such advice is not binding on the individual, we hope that this guide has shown that the complexity of the choice involved means that such advice should be taken very seriously.

We also believe that ongoing advice through retirement is of value, particularly if a transfer is made.  With the large sums that are now being offered to many people to transfer out of defined benefit pension rights, skilled management of the resultant investment pot is of the utmost importance.  This will help to mitigate against some of the risks identified in this guide.

There are several reasons to transfer your final salary pension scheme, all of which are personal to you, and these can generally be separated out into five categories:

1. Flexibility

2. Potential For Access To More Tax-Free Cash

3. Inheritance

4. Health

5. Concerns About The Solvency Of The Sponsoring Employer

1. Flexibility

Use the new pension freedoms that usually allow much more choice about how you use your money.

Use the new pension freedoms to access pension funds as you wish.

Use the new pension freedoms to have a more flexible retirement (ie allowing part time working) where a defined benefit pension is a fixed amount that cannot be changed once in payment.

Use the new pension freedoms so you can decide how you want to spread your income and spending through your retirement, rather than having a rigid amount throughout.

Use the new pension freedoms to spend more of your fund (income) in earlier retirement while your living costs are high, and you are more mobile and able to travel, then when you are not as active and your living costs have reduced, you can take less from your fund in middle retirement.  When you are in the latter years of retirement and may have care costs to consider, you can draw more funds to pay for these costs without having to sell the family home or other assets that you were planning to leave to your heirs.  Having a defined contribution pot to draw on enables you to make choices of that sort.

If you know that your life expectancy is likely to be lower than average due to illness, the new pension freedoms will allow you the flexibility to spend more of your fund (income) in earlier retirement while you are more mobile and able to travel or to provide for your family.

Flexibility of retirement income that better suits your future living requirements.

To be able to enjoy more flexibility as to when you can take both tax-free cash and income.

The ability to control the ongoing investment of your funds.

Additional flexibility on investments and risk.

If you are not intending to take cash now and just want your accumulated fund in a pension that has a lump sum value in the event of your death, so you can leave some money to your heir(s).

You may want to retire later in life and take tax efficient flexi-access drawdown at that point, which is also another plus for taking drawdown at this time.

You are looking to retire later and your ‘higher than average’ attitude to risk on investment choice works in your favour with a longer time horizon to taking benefits.

You may be planning several trips to visit relatives around the world and would expect to utilise your tax-free cash to pay for the trips.

You would, at some time in the future, like to use your maximum tax-free cash lump sum to take your dream holiday or buy your dream car and enjoy your early years of retirement.

You would, at some time in the future, like to use your maximum tax-free cash lump sum to make the improvements to your home that are needed.

You would, at some time in the future, like to use your maximum tax-free cash lump sum to clear your existing debts.

You may wish to raise a capital sum from your defined benefit schemes to be able to pay for a loved one’s long-term care costs.

You may wish to release the maximum amount of tax-free cash available from your pension, along with improving the capital death benefits available to your loved ones.

You would, at some time in the future, like to use your maximum tax-free cash lump sum to give much better overall financial security now, and in the immediate future.

You plan to retire at your intended retirement age and will use this pension to provide you with an income in retirement.

You may not feel the need to draw an income from these funds yet and you may have adequate income for the time being from other sources, but you may need the tax-free cash lump sum.

You may have a potential need for tax-free cash, but not to take an income, an option not available from your existing scheme.

You may have a need for flexible income to allow you to retire from your intended retirement age that is not an option with your existing scheme.

You would like to enjoy more flexible and potentially more beneficial death benefits than your existing scheme offers.

You might not currently have and may not have in the future a spouse or partner to share your current company benefits with.

You would like the flexibility offered by the new pension freedoms and flexi-access drawdown.

You may be considering moving abroad and the flexibility the transfer will give you will enable you to take a tax-free lump sum, as well as drawing an income.

You can take tax-free cash now and retain remainder of your pension fund until your normal retirement date.

You do not expect to live long in retirement, and want the flexibility to draw more funds early on.

2. Potential For Access To More Tax-Free Cash

Use the new pension freedoms so you can decide how you want to spread your income and spending through your retirement rather than having a rigid amount throughout.

Use the new pension freedoms to spend more of your fund (income) in earlier retirement while you are more mobile and able to travel, and spend less later in retirement, and having a defined contribution pot to draw on enables you to make choices of that sort.

You may be able to take a higher tax-free cash lump sum if you transfer to a defined contribution scheme than you can take from your final salary scheme.

Flexibility of retirement income that better suits your future living requirements.

The current high level of transfer values offers good value for your pension fund that in turn could mean a higher tax-free lump sum.

You want to be able to enjoy more flexibility as to when you can take both tax-free cash and income.

You want more tax efficiency in how you extract your pension funds.

You are not intending to take cash now and just want your accumulated fund in a pension which has a lump sum value in the event of your death, so you can leave some money to your loved ones.

You want to retire later in life and take tax efficient flexi-access drawdown at that point, which is also another plus for taking drawdown at this time.

You may be planning several trips to visit relatives around the world and would expect to utilise your tax-free cash to pay for the trips.

You would, at some time in the future, like to use your maximum tax-free cash lump sum to take your dream holiday, or buy your dream car, and enjoy your early years of retirement.

You would, at some time in the future, like to use your maximum tax-free cash lump sum to make the improvements to your home that are needed.

You would, at some time in the future, like to use your maximum tax-free cash lump sum to clear your existing debts.

You may wish to raise a capital sum from your defined benefit schemes to be able to pay for a loved one’s long-term care costs.

You may wish to release the maximum amount of tax-free cash available from your pension, along with improving the capital death benefits available to your loved ones.

You may wish to release the maximum amount of tax-free cash available from your pension, along with improving the capital death benefits available to your loved ones.

You would, at some time in the future, like to use your maximum tax-free cash lump sum to give much better overall financial security now and in the immediate future.

You may be considering moving abroad and the flexibility the transfer will give you will enable you to take a tax-free lump sum, as well as drawing an income.

You have a potential need for tax-free cash but not to take an income, an option not available from your existing scheme.

You would like the flexibility offered by the new pension freedoms and flexi-access drawdown.

You can take tax-free cash now and retain remainder of your pension fund until your normal retirement date.

You may want to take your tax-free cash and invest the money yourself.

3. Inheritance

Your spouse may benefit more following your death when you transfer as most defined benefit schemes only pay the full pension to a widow(er) for a minimum period of time, whereas as in a defined contribution scheme you can state who to leave your pension money to.

Your partner (if of the same sex couple or unmarried) may benefit more following your death when you transfer, as there may be less rights for your partner in a defined benefit scheme, whereas in a defined contribution scheme, you can state who to leave your pension money to.

Your dependent children may benefit more following your death as there may be some entitlement from the defined benefit scheme (in most cases the pension dies with you), but in the defined contribution scheme, you can state who to leave your pension money to.

Your non-dependent children will benefit more following your death when you transfer as you will be able to leave them some or all of your pension fund.

Whoever you want to leave your money to may benefit under the recent pension changes when considering the tax treatment of the fund.  If you die before age 75, then the cash balance can be received tax free.  If you die over age 75, then your heir(s) will only have to pay income tax in the normal way when withdrawing.

Your current final salary pension does not allow you to leave your pension to your grandchildren.  Transferring out will allow you to leave the remainder of your fund to your grandchildren.

If your heir(s) do not draw on the inheritance, it can be passed onto their heirs.

More tax efficiency in how your heir(s) extract your pension funds following your death.

You have dependent children who you would like them to continue to receive benefit, in the event of your death, and more importantly, after they become non-dependent.

Your partner does not have any pension savings, so you wish to ensure that in the event of your death, they will have sufficient income in addition to their state pension.

You currently have non-dependent children who you would like to benefit from your entire estate in the event of your death.

You are not intending to take cash now and just want your accumulated fund in a pension that has a lump sum value in the event of your death, so you can leave some money to your children/grandchildren.

You would like, as far as possible, to leave any remaining funds to your partner and or family in the form of a lump sum benefit, or beneficiaries’ drawdown, in the event of your death.

You may wish to release the maximum amount of tax-free cash available from your pension, along with improving the capital death benefits available to your loved ones.

You would like to leave any remaining funds to your family in the event of your death, in both the short term and long term.

You are keen for the full value of the transferred fund to be available to your family and not just part of it now and in the future.

You would like to enjoy more flexible and potentially more beneficial death benefits than your existing scheme offers.

You have non-dependent children who would not benefit on your death with your current scheme who you would like to benefit from any remaining funds on your death post transfer.

Although you currently have dependent children who benefit from your current deferred benefits, they will in the future become non-dependent and not be eligible for any benefits from your existing deferred pension(s).

The inheritance tax treatment of money held in defined contribution pension pots was made much more attractive.

It is, of course, possible to turn your pot of money into an income for life, with an income for your surviving partner, if you were to die.

4. Health

Use the new pension freedoms to spend more of your fund (income) in earlier retirement while you are more mobile and able to travel, and spend less later in retirement, and having a defined contribution pot to draw on enables you to make choices of that sort.

If you know that your life expectancy is likely to be lower than average due to illness, the new pension freedoms will allow you the flexibility to spend more of your fund (income) in earlier retirement while you are more mobile and able to travel or to provide for your family.

Flexibility of retirement income that better suits your future living requirements.

You are in poor health that could have an impact on your longevity, and would like to draw more money sooner to help ease the financial burden.

Neither you nor your partner are in good health and would like to draw money sooner to help ease the financial burden.

You are single and in poor health, so the new pension freedoms will allow you the flexibility to spend more of your fund (income) in earlier retirement while you are more mobile and able to travel.

5. Concerns About The Solvency Of The Sponsoring Employer

Should the company (your employer) that sponsor the defined benefit scheme go insolvent, you may not get the full amount of money in the pension fund.  If you transfer out, this will not happen as the defined contribution scheme is not sponsored.

The existing scheme’s financial position is not good and there is concern that it will tip into the Pension Protection Fund that could result in you receiving less of your pension fund.

You might be worried that the ex-employer standing behind your pension might not be there in years to come.

In addition to these five categories, there is a category that could prove useful and advantageous to people that are looking to invest in their own businesses.

Investment Opportunity

The current high level of transfer values offers good value for your pension fund.

More tax efficiency in how you extract your pension funds.

The ability to control the ongoing investment of your funds.

Additional flexibility on investments and risk.

The level of Cash Equivalent Transfer Values being offered to scheme members are at an all-time high due to low gilt and interest rates.  The high level of transfer value offered to you provides a unique opportunity for you to consider transferring your benefits now, as any future upward movement in interest or gilt rates will give rise to a reduction in transfer values in the future.

You may need to release funds to invest in your company or aid important cash flow requirements.

The low interest rate environment of recent years has meant that the transfer values being offered in exchange for defined benefit pension rights have soared to record levels.  This mainly reflects the fact that it is now costing defined benefit schemes a lot more to meet the pension promises that they have made.

If you want to use your defined benefit pension fund to develop your own company, a Small Self-Administered Scheme (SSAS) offers this option.

If you invest your defined contribution pension successfully, you may be able to achieve an above-inflation rate of return.

If you take a cash transfer and invest the money yourself, the value of your fund can, and will, go up and down.  This could have a considerable upside in that your assets might appreciate considerably.

When you transfer out of a defined benefit pension scheme, you are transferring investment risk from your old employer’s shoulders onto your own shoulders.

The low level of interest rates and the terms of the pension might result in a multiplier of 30 being applied.

Case Studies

The Following Are Case Studies Of Previous Clients Outlining Their Reasons For Wanting To Transfer

Tom, aged 60, was single with a non-dependent son.  His pension fund was £201,530.  He was healthy and looking to take early retirement at 61 to fulfil his lifelong dream of travelling the world.  Tom was able to take his tax-free cash lump sum as soon as the transfer went through.  Had he stayed in his final salary defined benefits pension scheme, he would have had to wait until the scheme retirement age of 65 before he could take this amount.  He also wanted to be able to leave his son some money in the event of his death, something his defined benefits pension scheme wouldn’t do.  Following the transfer, when Tom passes away, the remainder of the pension fund will be inherited by his son.

Shirley, aged 55, was married to Richard.  Shirley had health issues that meant her life expectancy would be cut short.  Richard was not working as he was Shirley’s carer, and Shirley wanted to ensure that her pension fund of £159,231 could be utilised to provide financial stability for the short term, and following her death, Richard would have some money to live on.  Shirley wanted to take the maximum tax-free cash immediately so that they could have their house adapted for wheelchair access.  Her defined benefits pension scheme would have restricted the work that they could have had done to the house as she would not have been able to take her tax-free cash until she had reached her scheme retirement age of 60.  Following the transfer, Shirley was able to make sure that following her death the remainder of the pension scheme went to Richard.

Reg, aged 63, was married to Rebecca, both in good health.  Rebecca had her own pension with flexible drawdown.  Reg’s defined benefits pension would pay him an income of £25,000 per annum for the rest of his life.  They live in their own home, with no mortgage and had no debts, and no need for any tax-free cash.  For these reasons, we advised Reg that it would be in his best interest to stay with his final salary pension scheme, and if there came a time that they needed some tax-free cash they could take it from Rebecca’s pension.

Harold, aged 58, was single.  He was looking to retire at 65 but was concerned about the stability of his final salary pension scheme with his previous employer, as he had heard that they were struggling financially.  Harold would rely on the income from the pension as he had no other investments, and his business was not performing well.  Following the transfer, Harold was able to take some tax-free cash to invest in his business to help it grow.  The previous company had the administrators in and had to close, which meant that all pensions fell to the Pension Protection Fund, and Harold would have lost out on 10 per cent of his pension fund.

The Following Are Case Studies Of Previous Clients Outlining Their Reasons For Not Wanting To Transfer

David, aged 60, was married to Dawn, with two non-dependent children.  Both he and Dawn were in good health.  David’s pension fund was worth £231,603 and he was looking to retire as soon as possible as he was in a job that he didn’t enjoy.  His defined benefits pension would only allow him to take an income from age 65.  Both David and Dawn had other investments and savings.  The transfer value was a generous offer and David could see the merit of transferring his defined benefits pension, as this would allow him to provide for Dawn and the children in the event of him passing away.  After much deliberation on the matter, David decided not to go ahead with the transfer, as work had started to get better, and although the transfer looked attractive, he wasn’t 100 per cent sure if it was the route he wanted to take.  Our advice in this instance was to remain in the scheme, as if there is any doubt on the part of the client with regards to risk exposure, then the advice should always be to remain in the scheme.

Lynda was aged 58 and single.  She lived alone and had one non-dependent son aged 18.  She was in good health with no ailments.  She was about to take a six month sabbatical from work.  She was aiming to retire at age 65 and didn’t require any tax-free cash.  Lynda expected to inherit around £200,000 and had £275,000 in savings.  Having run the transfer value and cashflow analysis reports, the transfer value did not offer a good return to Lynda.  There were no extenuating circumstances to make the transfer a viable option for her.  We therefore did not recommend that the transfer take place.  However, should her circumstances change in the future, particularly regarding her health, she should look again to see if the transfer would be a good option for her.

Charles was aged 36 and soon to be married to his partner.  Neither had any children.  His health was good.  He was self-employed and was planning to retire at 60.  He had no savings but did own his own home with a mortgage on it.  Having run the transfer value and cashflow analysis reports, the cashflow analysis report showed that the pension would run out a long time before Charles’ life expectancy.  There were not any extenuating circumstances that would support the transfers from his defined benefits pension.  Therefore, Charles remained with the defined benefits pension as it offered much better benefits to him right now.

Graham was aged 55 and lived with his wife Jane.  Both were in excellent health with no ongoing medical conditions.  They had five non-dependent children.  Both Graham and Jane were self-employed.  Graham was expecting a £200,000 inheritance and had £245,000 in investments.  They also owned their own home with a substantial amount of equity in it.  Graham was looking to retire at age 65.  The transfer value and cashflow analysis showed the transfer from Graham’s defined benefits pension to be a very good option for him.  His pension fund was worth in excess of one million pounds.  Although Graham could see that the transfer could offer a good return the him, he didn’t want to take the risk in case the worst-case scenario happened, and the pension didn’t perform as well as needed.  Our advice was to remain in the scheme as his attitude to risk was not sufficient enough to warrant the transfer.

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This guide has been written by Better Retirement Group Limited, a Financial Conduct Authority regulated firm of independent financial advisers that over the last 25 years has advised around 100,000 pension clients nearing or in retirement.  It has experience of both SIPP and SSAS.

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