There have been record levels of final salary pension transfers in the UK over the last couple of years. The cash equivalent transfer value (CETV) being offered to people who have deferred final salary pensions has never been higher. Although transfer values have triggered the review of many final salary arrangements, there are also other factors at work. There is a renewed push by final salary schemes to remind their members that they can consider transfers. This will enable employers to get them off their books for good.
Until very recently, ‘gold-plated’ final salary pension scheme benefits were nearly always considered the best option compared to the alternatives. Not least because the risk (or cost) of providing an index-linked income for life rests firmly with your former employer. But with the introduction of the new pension freedoms in April of 2015, the alternatives suddenly got a whole lot better.
Since April 2015, anyone over the age of 55 can access a money purchase pension whenever they like. They can take whatever level of income or cash lump sums they choose (subject to the tax rules). Alongside the added flexibility and investment choice of transferring to a money purchase scheme, the new pension freedoms also abolished the 55% ‘death tax’. This allows pension wealth to pass tax-free between generations. This has made personal pensions one of the most tax-efficient ways in which to pass wealth down through your family, free of inheritance tax.
As a final salary pension will be lost when you die, you can instead transform it into a major financial asset. That asset can provide both income and tax-efficient lump sums in retirement and still be passed on to your loved ones, free of inheritance tax when you die. Naturally, the attractions of such freedoms have exerted a strong pull on those with final salary scheme pensions.
Many people are, understandably, anxious about the security of their hard earned final salary pensions. The recent scheme collapses at British Steel and British Home Store (BHS) once again highlighted how final salary pensions can become hostages to fortune, prompting a good many Britons to take a closer look at the security of their own pensions.
Why such high transfer values?
The combination of our longer life spans and the low yields on government bonds, means annuity rates are now at their lowest levels. These are the same factors that drive annuity prices, which in turn drive the valuation of final salary benefits. This means that the cost to your final salary scheme of providing you with a final salary pension for life has never been higher. As a result, the cash equivalent transfer values (CETV) now being offered by final salary schemes as an alternative are also now at an all-time high.
Historically, the industry ‘multiple’ tended to float at around 20 (meaning a £10,000pa pension would equate to a transfer value of around £200,000). However, multiples in the 30s, 40s and even 50s are now much more standard. A high transfer value reduces the investment risk that you take on when you transfer.
The Benefits of a Pension Transfer
With a final salary pension, once you’ve selected your retirement date and received your tax-free lump sum, the pension income you subsequently receive will (at best) only ever grow in line with inflation. Moving to a personal pension arrangement delivers far greater income flexibility in retirement, along with numerous options for drawing down lump sums, all of which are useful for coping with life’s ups and downs. It can also help to significantly reduce the tax that you might otherwise pay if you received a set level of income from your final salary pension.
A pension transfer ‘monetises’ your final salary benefits by transferring them into a cash value. When you transfer this to a personal pension arrangement, your pension savings become an asset that can usually be passed onto your loved ones and their descendants. Personal Pensions are free of income tax (if you die before age 75) and free of any inheritance tax.
Those expecting a shorter innings will be paying too much for the income they’re likely to receive. That’s because the income paid by a final salary pension is priced on average life expectancy. Consequently, transfers have a particular appeal to those in poor health. In other words, because a transfer converts your pension benefits into a cash value based upon normal life expectancy, all else being equal, an ill-health transfer should be worth more to your family than your previous scheme benefits. This means that arriving at an informed decision about whether a transfer makes sense for you requires you to take a view on your own life expectancy.
Typically, final salary schemes will offer a reduced (50%) widow’s pension to your spouse once you die. This is actually an extremely expensive way to provide an income for your partner as it’s taxable. By contrast, a widow’s draw-down or annuity pension is now tax free (if you die before age 75). Remember, under a final salary scheme, the value of all your pension savings will be lost once you and your spouse have died.
There won’t be any additional tax to pay so long as the value of the benefits taken remains below the LTA limits up to age 75. Only when the value taken exceeds the LTA limit will a tax charge be made. Given that the pension pot has grown in a tax efficient environment for the intervening years, this can seriously reduce the total value that’s eventually lost to tax.
A transfer from a final salary arrangement will deliver far greater flexibility when it comes to drawing tax-free lump sums and income. And, by managing your income to remain below specific income tax bands, you can reduce your tax bills.
Many members of final salary schemes have accrued benefits that are well in excess of the current lifetime allowance (LTA) of £1 million. Those drawing an income of more than £50,000 pa will find themselves subject to LTA charges of 55% tax on any lump sums, 25% on any income in excess of the LTA, plus income tax (40%/45%), deducted at source. However, a transfer to a money purchase arrangement allows such LTA tax charges to be deferred to age 75.
Pension Scheme Deficits
The majority of defined benefit pensions are significantly underfunded. If the employer funding the final salary scheme fails, you could find your pension is in the hands of the Pensions Protection Fund. From 1st April 2017, someone aged 65 will receive 90% of their benefits capped at £38,505.61 (ie £34,655.05) per year, while future increases will also be reduced. This could represent a major loss of benefits for those who enjoyed relatively high earnings during their working life.
Final Salary Transfers: What are the risks?
If you transfer out of a final salary pension, you’ll lose any guarantee as to the level of income you receive in retirement. A transfer passes the investment risk that accompanies the provision of a lifetime income from your former employer to you. You can’t transfer back again should you change your mind. Outside of a final salary pension, the only way to effectively guarantee an income for yourself in retirement is by buying an annuity.
The Risk Is All Yours
A transfer means taking on investment risk as you’ll need to invest your pension pot in a range of different ‘risk assets’ such as equities and bonds. A high transfer value means that only modest levels of investment performance might be required in order for your new portfolio to deliver at least the same level of income as you would have received in your old pension. But remember, there are no guarantees whenever investment performance is required.
Although a pension transfer gives you the flexibility to create and manage your own pension pot that can be passed to your beneficiaries, it’s important to appreciate what you’ll be giving up in return. There is no guarantee that you won’t run out of money in retirement. Also, there are no guarantees that your new pension portfolio will generate a higher level of income than the one your previous scheme was offering. Hand in hand with this is the risk that if you fail to manage your withdrawals correctly, you could exhaust your pension pot before you reach the end of your retirement.
There’s no such risk with a final salary arrangement. You’ll need to find an adviser who can produce a ‘cash flow model’. The cash flow model will illustrate just how well your new pension pot will need to perform, in order to match the level of income you would have received from your final salary pension.
Why I am sticking with my final salary pension….for now
Now, for those of you who follow my ‘Tracking Our Assets & Liabilities‘ posts, you maybe wondering why I haven’t cashed in my final salary pension.
I haven’t actually asked for a Cash Equivalent Transfer Value (CETV) for my final salary pension. If I was to ask, I suspect I would get the bog standard offering of around 20 times annual income. As far as I know, the higher valuations have come from schemes proactively making the offers to members, in order to wind down the schemes liabilities.
However, I am 45, and with stock markets at an all time high, for me, it’s too risky taking the money right now. Any money transferred would need to be invested in something other than cash to keep pace with inflation. I don’t like bonds at the moment, and equities are expensive. The final salary pension is guaranteed income that will rise with inflation. I should have the choice anytime in the future of transferring. So for me, there is no point taking unnecessary risk. The best time to transfer would probably be nearer to retirement and after a serious stock market correction.
That said, it is something that I will seriously consider doing from an inheritance point of view, in maybe 10 years from now. If my employer offered me £600,000 for my final salary pension tomorrow though, it would be hard to turn down!