Recent regulatory changes and favourable markets have made defined benefit (DB) pension transfers a hot topic. But what are the risks, and could a transfer be worth considering?
Defined benefit pension transfers first emerged in the 1980s, when a rule-change created a market for private pensions. Many people gave up their employer-defined pensions (where benefits are based on a member’s salary, years of service and accrual rate) in the hope of greater gain from a personal defined contribution (DC) pension. Unfortunately, the first wave of DC pensions often turned out to be the financial equivalent of magic beans, and many people lost out.
More recently, pension liberalisation reforms and low gilt yields have combined to bring pension transfers back into the spotlight.
DB pensions: the nuts and bolts
DB pension transfers occur when pension holders give up their DB pension in exchange for a lump sum, known as a “cash equivalent transfer value”. This lump sum is then transferred into a DC pension, where what people receive depends on the contributions made, how well they are invested and any charges applied to the plan, plus annuity rates and interest rates.
Traditionally, it was almost always deemed a bad idea to transfer a DB pension into a DC pension scheme. It is important to understand that under a DB pension, the risk (and the obligation to pay a fixed amount) lies with the employer, whereas with a DC pension, the risk lies with the individual and payments are not guaranteed. Significant rule changes have taken place in recent years, but it’s still appropriate to take a cautious approach.
The red flags you should be aware of
We still start from the assumption that the transfer is inappropriate, and there are certain red flags that we look out for. For example, someone who needs a guaranteed income in retirement can rely on a DB pension scheme to provide that promise, whereas choosing to transfer would mean giving that up.
Some people believe the transfer values are so high they can do the transfer and still buy an annuity on the open market of a higher amount than they are getting on the DB pension. But our experience is that is almost certainly not the case.
The right circumstances
For people with a very long life expectancy (such as an individual with a family history of longevity), a DC pension introduces risk that may not be in their best interests when compared with a guaranteed DB pension.
Separately, there are also circumstances in which choosing a DB transfer would lead to the loss of transitional protection (including enhanced or fixed protection) from lifetime allowance taxation.
Poor health can be an incentive to make a transfer. A DB pension is payable during the holder’s lifetime. If the member dies, usually a portion is paid in their spouse’s lifetime, but after the death of the spouse, payments cease.
If you are in poor health or if you die before retirement, taking the lump sum could provide better protection for your spouse or your children than a DB pension.
Knowing the risks
Some pension schemes have benefitted from high investment returns in recent years: they offer enhanced incentive payments for people to take a transfer. Such deals may tip the scales in favour of making a DB transfer. If someone is quite comfortable with investment risk, it may be worth making a transfer to reduce the risk of dying without receiving the full value of the pension scheme.
The risk of corporate failure, where the employer is no longer able to honour its pension commitments, can also be a factor. If this happens, the DB pension is usually transferred into a government-run Pension Protection Fund. The holder loses the right to make a pension transfer, and the value of the pension is usually reduced, typically to around 90% of what was originally owed.
Furthermore, the Pension Protection Fund only provides protection up to a certain level, and so people with very high DB pensions, for example £60,000 or £80,000 per year, stand to lose significant benefits if their DB pension collapses.
Other reasons for making a transfer include a desire to leave the UK permanently or to withdraw a pension earlier (at 55 rather than 65, for example). Having a DC pension also allows for wealth to be passed on to the next generation on death in a manner that DB pensions do not facilitate.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
This article was previously published on Smith & Williamson prior to the launch of Evelyn Partners.