Wealth Planning in focus

Should I stay, or should I go?

There are around 11 million people who have built up benefits in private sector defined benefit pensions and its seems that higher transfer values are increasingly tempting people to leave these so called “gold-plated” schemes.

According to The Pensions Regulator, 67,700 people transferred out
of defined benefit pension schemes in the last year alone.

There has been a huge increase in interest in defined benefit (aka Final Salary) pension scheme transfer values since new pension freedoms legislation was introduced by Chancellor George Osbourne in 2015. According to The Pensions Regulator, 67,700 people transferred out of defined benefit pension schemes in the last year alone.

The BBC reported on this hot topic in December 2016 under the headline ‘’Defined benefit pension transfer values shooting up’’. According to the insurance company Royal London, six million people with defined benefit pensions have seen their transfer values increase significantly in the last year. The insurer suggests some members are being offered “eye-watering” sums, often tens of thousands of pounds more than a year ago. For an individual with a pension income worth £20,000, it is not uncommon to be offered 30 times that amount, in other words, £600,000 in cash.

Royal London’s survey of more than 800 financial advisers found a growth of more than 50% in the volume of transfers out of de ned benefit pensions taking place in the last year, with the most common transfer value lying in the £250,000 - £500,000 range. The vast majority of clients transferring were in their 50s, and the typical cash sum offered is between 25 and 30 times the value of the annual pension given up.
So why are so many people transferring out of these schemes that o er a guaranteed payment for life? The answer is twofold: Transfer values for de ned benefit schemes have been at inflated levels recently and secondly, the recently introduced pension freedoms that provide for vastly improved flexibility in how a pension can be taken applies to Defined Contribution (DC schemes) only.

 

Inflated transfer values

Transfer values are the sums paid from a pension scheme when a member chooses to withdraw their entitlement. In the past, lack of knowledge and lethargy meant many people kept pensions in previous employers’ schemes until they came to retirement.

The level of a transfer value from a de ned benefit scheme is not specified in the scheme’s rules, unlike other benefits. The terms used are set by the trustees, on the advice of the scheme actuary, at the time of the transaction. Transfer values paid from defined benefit schemes are the only ones that require assumptions about the future. Also, due to the pooling of risk between members, the level of transfer payment can also affect other people’s entitlements. The scheme actuary’s aim is to calculate the “best estimate” of the amount needed to buy the equivalent to the scheme entitlement. The actuary has to tread a careful line to be fair to both sides, ensuring any transferring member and those remaining in the scheme are not left worse off. He also has to be mindful that schemes have to guarantee their transfer value quotations for a period of at least three months to give members time to make arrangements with an insurer.

So let’s briefly look at the reasons for the increased transfer values in the last couple of years which has sparked increased interest from members.

Transfer value calculations require assumptions about discount rates, inflation rates and demographic assumptions, all of which apply many years into the future and so there is considerable uncertainty over how these factors will play out. Discount rates are often based on long-dated bonds adjusted for the scheme’s actual asset mix. Currently gilt yields are at low levels, which results in lower discount rates and higher transfer values. At the same time, the long- term inflation rate outlook has risen, which also tends to increase transfer values in many defined benefit schemes.

There was a large fall in gilt yields over the period just after the Brexit vote. Although the fall reversed towards the end of 2016, it looks to be slowly falling again in 2017. Transfer values are likely to have followed an inverse path depending on the scheme’s rules.

These higher transfer values attract more members to transfer out as they might expect that such a relatively high transfer value can be invested to provide a higher return and result in a greater pension than the more prudent assumptions used by the scheme actuary.

Members requesting transfer values last autumn are likely to have done well. Experience suggests they may also have told their friends and families about the relative size of their transfer values, encouraging more people to consider transferring.


Pension freedom

Members transfer for different reasons. They might feel more secure with a policy in their own name, in case anything happened to the scheme; the recent BHS debacle is an example of this. Or perhaps they want to have all their pensions in one place. It also allows defined benefit members to tailor their pension to suit their own needs, where these differ from those in the scheme’s rules, for example by:

Taking pension earlier or later than the scheme rules offer 
Allowing for different levels of inflation protection
Altering the level of dependents’ pensions to provide more or less for a spouse, or to remove them completely if they have no dependents

Pension freedoms introduced in 2015 changed this in a big way, encouraging more members to transfer. Since 2015 holders of defined contribution plans:

Do not have to buy an annuity 
Can draw their pension flexibly
Can even take the whole pot as cash, although this would be subject to tax


The important point is that these freedoms only apply to members of defined contribution schemes, so if defined benefit scheme members wish to take advantage of the flexibilities, they must transfer. Publicity over the new legislation also seems to have spurred people into considering their own pension and taking action.

It must be noted however, that if a scheme is underfunded, paying out a full transfer value could mean remaining members are left worse off. Underfunded schemes, those with a poor outlook for returning to full funding, may reduce transfer values (an “actuarial reduction”) so as not to disadvantage those left behind even further.


Transfer incentives

Over the past few years, more defined benefit schemes have closed and sought to reduce the risk in their scheme. Royal Mail confirmed earlier this year that it will close its defined benefit pension scheme to future accrual and retail giant Marks & Spencer told its active defined benefit members that they will no longer be able to accrue additional benefits from April 2017.

One way to further reduce risk for the scheme trustees is to reduce the number of members and the size of the scheme’s liabilities, which means the members who transfer out are helping the de-risking process. This has led some schemes to offer incentives, by increasing transfer values, as an inducement to transfer away.


Should you stay?

While obtaining the cash value of a defined benefit pension may be beneficial for some people,
there can be significant disadvantages. Keeping a defined benefit pension is sensible for many people, as they offer:

Certainty: such pensions pay an income for life 
Inflation protection
Risk-free income, which does not depend on the ups and downs of the stock market

It is a regulatory requirement that anyone seeking a transfer over £30,000 must seek advice from a suitably qualified  financial planner and the trustees of the ceding defined benefit scheme must ascertain that this has been done. Otherwise, the transfer is not permitted.

We would encourage members of defined benefit schemes to seek advice to review their situation and their entitlement from the scheme, including the benefits at retirement and the relative transfer value offered. The advice process can often be complex and a member should consider carefully their options with their adviser. Giving up a guaranteed payment for life is a big decision so any action should not be taken without due consideration.

The points made in this article are for illustrative purposes only and if you require any assistance with any of the above opportunities in relation to your personal circumstances, contact your investment manager who can make an introduction to our specialist wealth planning team.

It is important to note that JM Finn is not a tax adviser and where tax advice is required, we would look to work with your existing advisers or refer you to a trusted external tax specialist.

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