Final salary or defined benefit schemes have long been considered the ‘Rolls Royce’ of pension provision. For most individuals the promise of the guarantees they offer should not be given up. However there are some circumstances in which an individual and their dependants can be better off by doing so. One of these circumstances is ill health of the member of the pension scheme or their dependent.
Final salary schemes do not take any notice of an individual member’s life expectation. So unlocking the transfer value can result in an increase in the income provided where lifestyle or medical history qualify for enhanced terms for a lifetime income from those insurance companies which will take this into account. It is even possible for higher levels of income to be available where health or lifestyle indicate a lower than average life expectation. This may also result in a higher tax free lump sum being available.
What’s more, the timing of the start of the pension and the way in which the income is guaranteed can be designed around the individual’s needs rather than being determined by the defined benefit scheme rules which apply to all members regardless of their personal circumstances.
Final salary schemes are required to offer members who have not yet taken their pension a cash equivalent transfer value which can be transferred to another pension scheme. Thereafter the final salary benefits are given up.
What are you giving up?
A final salary 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.
How does it work?
The transfer value is paid into another pension scheme, usually a personal pension or stakeholder pension owned by the member. Benefits drawn from the pension scheme from then on will depend upon whether:
- The income is to be arranged on a guaranteed basis, determined by gilt yields and expected lifespan of the pension owner /dependant or
- Is to be drawn from the fund value and will depend on future investment returns achieved with no guarantees in place resulting in a higher or lower income.
A hybrid approach is also possible.
We will look in detail at the first of these options and follow up on the others in subsequent articles.
What is ill health?
Any medical condition or lifestyle factor which reduces life expectation from the average can result in an increase in the income offered on a guaranteed lifetime basis. Smokers, those who are overweight, family history and address can all result in a higher income being offered. Those taking regular medication, for example, for conditions as common as high blood pressure or raised cholesterol will be offered extra income.
More serious conditions such as diabetes, heart disease, stroke or most forms of cancer can qualify for considerably higher levels of income from insurance companies which offer enhanced lifetime income guarantees. Over 60% of applicants qualify for increases of up to 30% extra income compared to someone of their age who is in good health.
How to access the enhanced lifetime income market
Before accepting the transfer value you need to obtain indicative quotations from the whole enhanced lifetime income insurance market. The income offered for a capital sum can vary by a wide margin from provider to provider. The best way to do this is via a whole of market specialist intermediary who can submit one medical form to all providers simultaneously
Once you accept the transfer value you will severe your entitlement to the final salary scheme pension.
If you give up a final salary scheme and take a transfer to your own pension the cash or income payable after your death will be determined by you and not by the scheme rules. Most final salary schemes will require any dependant’s pension to be paid to specified individuals only, for instance a spouse or civil partner and children up to age 23 if still in education. You may choose a wider definition for the survivor’s pension or opt for a single life pension if you have no dependants.
If you choose to buy a guaranteed lifetime income with your whole pension fund there is also the option of a minimum payment guarantee of at least five or 10 years’ payment of the income. So if your ill health does result in early death your nominated beneficiaries will at least get this paid to them.
It is also possible to protect the full purchase price, so that the balance of what has not been paid by the date of death can be paid to your nominees. Income and lump sums paid from private pension schemes are tax free where death occurs before age 75. If death is after age 75, the income or lump sums are taxed at the recipient’s marginal income tax rate. Payments of lump sums and income from final salary schemes are taxable at the recipient’s marginal income tax rate regardless of the scheme member’s age at death.
The next article in this series will examine the pros and cons of transferring a defined benefit pension into a drawdown plan where investment returns will determine the income received and lump sums left on death.
Please remember, no news or research item is a recommendation or advice to buy. Every Investor is not responsible for accuracy and may not share the author’s views. If you are unsure of the suitability of any investment for your circumstances please contact an adviser. All investments can fall as well as rise in value so you could get back less than you invest.