With cash equivalent transfer values at a long term high, you may be tempted to cash in your pension during this low interest rate era, but is that wise? The answer depends on personal circumstances and the type of pension plan under discussion.
The factors which will determine the outcome of the decision to transfer or not are variable and some depend on future events. A key factor is whether the pension is one which offers a promise of guaranteed future income or is simply an invested fund which can go up or down in value depending on investment returns.
These two types of pension are known respectively as defined benefit or final salary and money purchase. Today we will look at the decision to transfer from a defined benefit scheme and what you need to consider before doing so.
What are you giving up?
A defined benefit scheme offers:
- The promise of a guaranteed regular income at a given age, known as normal retirement age.
- This income is then paid for the life of the scheme member.
- It will also usually include an ongoing reduced level of income after the member’s death for any surviving spouse.
- The income usually increases once in payment by a given factor that may be partly inflation linked.
- There may also be a lump sum payable in the event of the member’s death prior to reaching retirement age, but it is often minimal.
The exact basis of the scheme promise will be detailed in the scheme rules which members are entitled to see. Most schemes give each member an annual update on the value of the benefits they have built up. Some statements are very clear, others require expert interpretation to really understand what the true value is.
Understanding the basis of the defined benefit promise is essential to the decision whether to transfer.
How does it work?
You are entitled to a cash equivalent transfer value instead of these benefits. A sum of money can be transferred to another pension scheme of your choosing.
Right now cash transfer values are at a very high level compared to long term averages. This is simply because interest rates and gilt yields are at an historic low and this is one of the factors used by the scheme to calculate transfer values.
However before giving up guaranteed benefits which may provide security in retirement for a telephone number sized transfer value, it is important to understand the extent to which the resulting pension fund would be able to match or improve your eventual retirement income and the risks you take in effectively converting a promise of a guaranteed income into an investment fund.
Transfers from final salary schemes in excess of £30,000 need to be signed off by a regulated independent financial adviser, other pension schemes cannot accept them without this. This consumer protection is there to help you avoid making an irreversible decision that could reduce your standard of living in retirement.
While the assessment will cost money it may very well be the best purchase you make if it helps you understand whether a transfer of your pension entitlement is right for you.
What might you gain?
So who might benefit from taking a transfer of their defined benefits pensions?
- A smoker or individual in ill health may not live long enough to get full value out of the defined benefit scheme as the income due will take no account of reduced life expectancy.
- A single person who has no plans to marry may benefit by using the embedded value of the spouse pension benefits to buy a bigger pension.
- Some schemes may offer survivors pensions on a discretionary basis, especially where a dependent partner is not a legal spouse or civil partner, transferring can give more certainty.
- If you wish to retire sooner than the normal retirement age of the scheme, this is granted at the trustees’ discretion and will usually be offered with a substantial reduction in the annual income. Early retirement from other pensions is permitted from age 55 onwards.
- If the defined benefit pension is a small part of your overall retirement income, the flexibility to manage when the income is paid and to pass on any residual fund to others may be attractive.
- Those with larger pensions who have exceeded the lifetime allowance may be able to receive a larger lump sum net of tax charges.
- Those who have concerns about the sponsoring employer being able to fund the pension may prefer to take a transfer to their own plan. The Pensions Protection Fund does not fully replicate pension entitlements and for those with pension entitlements in excess of £37,420 per annum the reduction can be substantial.
However transferring a defined benefit pension does mean giving up a promise of a guaranteed income for an uncertain one. It is a transfer of investment risk and cost of investing from the scheme to the individual, it can result in a lower or higher income and will certainly require more of your own time and money to manage.
The key question is will it improve your retirement lifestyle? In coming weeks we will look at a series of case studies to examine this question in more depth.