By Marc Ovits
BA (Hons) APFS Cert PFS (DM)
My article published two weeks ago focussed on the reasons why those people who are fortunate enough to have a defined benefit pension (final salary) are currently choosing to review these pensions.
Three primary factors were identified as driving the market.
- Pension Freedoms
- The demise of private sector defined benefit provision
- Current high transfer values offered by defined benefit schemes.
It is estimated transfer values have typically increased by more than 80% since the end of 2013 on the back of falling gilt yields, improved longevity and scheme investment derisking.
Over the course of this week and next, I would now like to focus on the advantages and disadvantages of transferring out of a defined benefit scheme and into a defined contribution scheme. However, prior to doing this, let’s review the differences between the two schemes.
A defined benefit pension scheme is where the benefits paid out usually in retirement are essentially known up front and guaranteed by the employer. The benefits will be inflation proofed and paid out in a fixed way.
A defined contribution scheme is where the ultimate benefits are unknown and not guaranteed. However, they can be taken flexibly. The idea is to maximise the contributions during the pre-retirement phase in order to create the largest possible pot from which income can be taken during retirement. The pot will usually be invested in financial instruments which are quoted on markets or in property – both of which are volatile resulting in the value of the pot or the benefits not being guaranteed.
What are the key benefits of transferring out?
1. Flexibility of benefits
One of the most often quoted reasons in favour of transferring out of a defined benefit scheme is to gain the flexibility of income and access to the pension fund that a defined contribution pension scheme offers, especially through drawdown. This is clearly true but it is not something that most people need or really want. That said, for those wanting to retire in stages over many years, having a single fixed date of retirement will not work for them and transferring is the only option to manage this later financial need. Few defined benefit schemes allow partial retirement because of the complexity it brings to their calculations. Late retirement is often an option in a defined benefit scheme but the factors may not be generous enough to make it worthwhile.
2. Tax planning
Phased retirement for those still in part time work can be a real benefit with regards to tax planning. If a pension is paid at the same time as earning a salary this may well push the individual into a higher tax bracket would just mean that more tax is going to be paid overall. Having the option to take a flexible income, especially early on in partial retirement, Gives the facility to take enough, but not too much income in any one year.
3. Death benefits
One of the biggest changes that came into force with the pension freedoms is the ability to use pensions for inter-generational planning. Death benefits under a defined contribution scheme can now be channelled to a wide range of beneficiaries such as dependence, nominees, and successors. However, as with other pension freedoms this is only available to those in defined contribution scheme is. This flexibility is especially appealing to those without a spouse or registered civil partner because, following the member’s death, defined benefit schemes will not pay benefits to anyone else although this is slowly changing for long-term partners. For those without a dependent that would benefit from defined benefit scheme death benefits, it is very tempting to transfer out just to gain the enhanced options on death benefits. However, it should always be remembered that pensions are primarily designed to pay benefits in retirement and providing for the individual in their lifetime should still be the main priority. Indeed, death benefits become irrelevant if the fund has been depleted in the member’s lifetime.
4. Those in ill health
Benefits paid from defined benefit schemes make no allowance for the health or longevity of the individual or their family, which could mean – in extreme circumstances – that the defined benefit scheme could be very poor value for money. Those who are approaching retirement, are in ill health, and want a secure income in retirement may benefit from an enhanced annuity that pays more than the scheme directly if they meet certain criteria set by the annuity providers. For those with serious health conditions that are not immediately life threatening, this could be a very good option to secure a higher income.
5. Controlling their pension fund
For some, the main reason to look at a transfer would be just to take control of their retirement. For example, they may feel that the company is unlikely to survive in the long term and fear their pension rights may end up in the pension protection fund (PPF). It is worth remembering that the PPF compensation Is 90% of £38,505 (£34,655) for 2017/2018 and the recent changes to the PPF Now mean that those with long service will have an increase to the cap. For many pension scheme members, leaving funds in the scheme with the risk of the PPF becoming involved they still produce a better financial outcome then transferring the funds to a defined contribution arrangement. Taking into account these fears is easy but getting any real feel for the longevity of some firms will be very difficult. So the advice may well have to address the uncertainty in a balanced manner. If the employees company is struggling, then it may well be in the members best interests to transfer; but it will also depend on many other factors because one area of concern just cannot override everything else.
Defined benefit pensions can be complex in their nature. A sensible option is to seek advice in this area from a competent financial adviser who can guide you through the issues and options.
The Writer is the owner and Managing Director of Alpha Wealth Management Limited. Drawing on over twenty years’ experience in financial services, Marc helps private clients, businesses, charities, and trusts optimize their finances. He is a Chartered Financial Planner providing ‘Independent’ financial advice. Prior to being a financial adviser, Marc was a Director at several global investment banks, providing investment advice to Europe’s leading institutional investment and pension fund managers. For advice on inheritance, investment, protection, or retirement planning, please contact Marc on 020 8203 6920 or 07866 503 898 or firstname.lastname@example.org.