Jonathan Watts-Lay, Director, WEALTH at work, a leading provider of financial education in the workplace, supported by guidance and advice, covers 10 things employees should consider before transferring from a defined benefit to a defined contribution pension scheme.
The pension changes for defined contribution (DC) schemes that came into force in April 2015, were not extended to defined benefit (DB) schemes. This means that individuals within DB schemes who wish to take advantage of the freedoms are first required to transfer to a DC arrangement.
However, those with a DB pension value of over £30,000 (and in some circumstances less) will need to take regulated advice and provide evidence to their scheme trustees before transferring to a DC arrangement. The Financial Conduct Authority (FCA) has estimated that 35,000 people a year will fall into this category and will need to take advice.
In addition, there are likely to be thousands more with a DB pension pot of less than £30,000 who want to transfer out and can do so without the need to take advice; but is that a sensible option and will employees be able to get a good deal?
Please see below 10 things employees should think about before they sign on the dotted line:
- Is the cash really needed?
Individuals need to make sure they have a purpose for the cash, as drawing on pensions has tax implications. Usually, the first 25% is tax-free but the remainder is taxed at a marginal rate of income tax. If it sits in a bank account afterwards, the interest may be subject to income tax (and that’s if it pays out an interest rate). Also, there is the question about whether it is better to have a cash lump sum or a guaranteed income; the schemes commutation factors are really important here but perhaps beyond the working knowledge of a typical employee? Transferring out may be appropriate for someone who for example, does not require dependent benefits, is in significant ill health, or requires a large cash sum to start a business or pay off debts, which are creating life pressures. But these are by no means hard and fast reasons for doing so and very much depend on an individual’s own circumstances.
- Is the paperwork correct?
When making the decision, individuals need to make sure that all the information is correct. We have heard of and seen transfer value statements arriving with confusing pension income figures which can leave even pension professionals confused. This is because they tend to quote the pension entitlement at the date the employee left the scheme. This could have been many years ago and with deferred pensions benefiting from annual inflationary increases; the actual pension entitlement at the date of the statement could in fact be a lot higher. It may be correct, but it could create a misleading picture and this makes a big difference when making a decision about whether or not the transfer value offered looks like a good deal.
- Compare the transfer value against annual income
A simple calculation is to compare the cash equivalent transfer value against the ‘current’ annual pension entitlement (not the pension at the date of leaving the scheme), to find out how many years annual income would need to be received before reaching the transfer value offered. For example, if a DB annual income guarantee is £1,355.58 and the transfer value is £27,384, then the conversion factor would be twenty times (27,384/1,355.58 = 20.20). This could be seen as twenty years of income and is a useful calculation when considering if it’s a good deal or not. However, note that it is not an accurate definition of ‘value’; the annual DB pension usually increases each year to maintain its purchasing power (indexation), but it’s unlikely that individuals are going to leave the transferred money sitting in cash, earning no return. They are likely to be invested with the prospects of fund growth, which needs to be considered (but also may be subject to market risk). Also, consider what happens if you outlive your DC pension pot. Whatever your choices, as ever, the tax implications need to be well understood too.
- Don’t forget the extras
Most DB schemes have very good benefits. Often they include 50% survivor spouse’s pension and possibly pensions for dependent children. Some offer increases of up to 5% on the deferred pension until benefits are taken and provide inflation proofing once in payment. Others have an element of death benefits in payment if the policy holder passes away within five years of receiving benefits. Some DB scheme members may also be entitled to ‘scheme protected tax free cash’ at a rate higher than the standard 25% – a benefit likely to be lost if transferred into a DC arrangement. If not carefully considered, these benefits are easy to overlook.
- Compare the value against an annuity
A bit like the comparison in number 3, individuals should look at and compare what kind of pension fund would be needed in a DC arrangement, to buy a similar income to those guaranteed by a DB scheme based on the same level of benefits e.g. joint life and index linked. With annuity rates at a ‘low’ level, the figures may surprise you and make the transfer look a lot less attractive.
- Check the Guaranteed Minimum Pension (GMP) value
The GMP is the minimum pension value which an occupational pension scheme has to provide for individuals who were contracted out of the additional state pensions between 6 April 1978 and 5 April 1997. Individuals may want to check the terms and entitlements carefully as some GMPs increase at high fixed rates (up to 8.5%) before retirement. This is not something to give up lightly.
- Changing transfer values
DB transfer values can fluctuate year to year based on a range of factors such as investment performance and mortality rates. This can impact the underlying scheme value and lead to varying transfer calculations. There may not be a best time to transfer, but individuals should check to see when their scheme last had a formal re-valuation.
- Transfer Value Analysis Systems (TVAs)
Calculating accurate transfer values is incredibly complicated and even financial advisers turn to their TVAs for guidance on how to value a DB pension. Individuals may want to consider if they want an expert to do this for them.
- Will the scheme pay out?
Some individuals are worried whether their scheme is secure, and if it will be able to continue to pay out as promised. Transferring out may be something to consider if the company is in a precarious financial position, but they shouldn’t act in haste and should weigh up all options before making any decisions. In the event that the Sponsoring Company becomes insolvent and its scheme is accepted for entry into the Pension Protection Fund (PPF), the PPF will pay up to 90% of their pension subject to an annual cap (90% of the 2015-2016 annual cap at age 65 is £32,761.07).
- Are individuals equipped to understand their options without advice
Ultimately pension transfer documents are often unclear, full of jargon and it is hard to understand the value of the actual benefits that will be given up. Taking regulated financial advice should not be under estimated and can offer added protection against making costly mistakes, and always check you adviser is regulated by the FCA for protection against potential scams.
Overall, it is important to remember that the FCA and The Pensions Regulator still believe that transferring out of a DB scheme will not be in an individual’s best interest, for the majority of people. The adage ‘invest in haste and repent at leisure’ has never been more appropriate. Individuals must now think about their finances – not just in terms of their pensions, but all of their savings such as; ISAs, shares and any cash savings, plus those of their partners. They then need to consider their tax status, health, longevity, property, and any possible inheritance etc. This demands a holistic approach to retirement planning.
I believe the ideal is to provide a full service for employees in the workplace: financial education, to help them understand the pros and cons of each retirement option, followed by regulated advice to provide individual support. Finally, employees should be able to implement their retirement plans whether they decide to buy an annuity, go into drawdown or simply make cash withdrawals in a tax efficient way.
Therefore, employees should take their time and if they are in any doubt, they should ask a professional.