James Baxter discusses the issue of whether clients need to consider transferring their deferred defined benefit pensions
Staying in a final salary scheme is going to be the right decision for the majority of those who have built up a defined pension benefit from a past employer. Its security, along with limited risks and effort on the part of the member, are attractive features that should not be passed up lightly.
However, for those with larger benefits and other investment assets to fall back on, taking a transfer to a personal pension can be an attractive option. While transfer values are at their most generous, 2013 could turn out to be a unique opportunity to review this option.
Transfer values, which represent the cost of replacement benefits bought in the open market, have to take account of the rising cost of annuities, which rise as gilt yields fall.
A deferred pension benefit that had a transfer value of around twenty times the deferred pension in 2006 could now have a value of thirty times this amount. While scheme benefits have typically only risen by around 3% per annum since 2006, the equivalent transfer values have grown around 10% compound.
How transfer values have out grown scheme benefits
This example would be a for a typical final salary scheme paying 3% benefit increases to deferred pensioners over the last six years and are based on a member who was 50 in 2006.
| Deferred pension
|| Typical transfer
|Benefit in 2006||£50,000 pa||£1,000,000|
|Benefit at end-2012||£59,700pa||£1,800,000|
Why take a transfer value?
A high transfer value in itself is not sufficient reason to move out of a final salary scheme.
If you and your spouse are in reasonable health, and it suits you to have the same ‘shape of benefits', i.e. a lump sum at age 60 followed by a guaranteed lifetime pension and reduced spouse's pension, then even if the transfer value is generous, it would probably be prudent to stay in the scheme.
If your plan post transfer is to buy a guaranteed annuity at 60, you gain very little and would take on more risks, costs and management responsibility by leaving the scheme. This would not make sense unless you were worried about the covenant of the scheme.
To make the transfer route worthwhile there should be a different ‘shape of benefits' attractive to the individual that can be arranged via a personal pension. While final salary schemes can offer great security they are inflexible;
• Tax free cash sums have to be taken at one point in time; coinciding with the start of the pension.
• If you do not happen to have a spouse, or you are in poor health there is no way to get enhanced benefits.
• You cannot vary pension payments to accommodate gradual retirement, or in the event you do not need the pension.
With a personal pension, phased retirement, income drawdown and the new flexible drawdown rules there is significantly greater flexibility as to how a generous transfer value can be put to good use.
This can range from full encashment at 55 once the £20,000 per annum secured income has been satisfied, to full deferment and exploitation of the exempt fund status to age 75.
The biggest risks in going the transfer route are around generating an inflation plus investment return and longevity.
A sensible investment strategy, limiting risk and beating inflation after fees, while having other investments and income, should be a prerequisite to leaving a final salary scheme.
Are high transfer values a temporary phenomenon?
Driven to record low levels by risk aversion, low inflation and quantitative easing, many think gilt yields are now at rock bottom and warn of a potential bubble in prices that if burst would start yields rising again.
If gilt yields start to rise, current sky-high transfer values may prove to be a temporary phenomenon that some may regret missing out on.
A complex high-value transaction
Leaving a final salary scheme can potentially enhance an individual's assets by hundreds of thousands of pounds and may be the biggest transaction they undertake with their own cash. It is both complex and irreversible.
Bigger benefits may have tax complexities around protection from the life time allowance and most members will want professional advice before moving.
James Baxter is partner at Tideway Investment Partners.
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