Pension schemes that provide an income based on final salary have long been held out as the gold standard of retirement provision and indeed, if the person lives a very long time – beyond their life expectancy – they will provide a very high total return.
Defined benefit (DB) schemes are, however, also inflexible – simply allowing a person to take an initial tax-free lump sum and then providing a fixed income each year, increasing in line with inflation. Should the scheme fall into default – recent high-profile examples being BHS, British Steel and turkey firm Bernard Matthews – the safety net is the Pension Protection Fund, which results in a cut in pension entitlements and limited protection against inflation.
Since the introduction of pension freedom, there has been a significant increase in the number of people deciding to transfer from DB schemes into a personal pension – and yet the number of people doing so is still very small compared with those actually retiring from the schemes. So why is this number so small when, in reality, more than half the members of such schemes would eventually receive more cash following a transfer than they would by just drawing the DB income?
Take the example of a person whose pension after cash might be £3,600 a year. The transfer value in exchange for this could well amount to £100,000 with today’s high cash equivalent transfer values. If that person died within five years of retirement they would have received less than £20,000 and if they were single, no further sum would be payable.
Indeed, it would actually take 21 years before more cash has been received than the £100,000 offered as the initial transfer value, and the growth earned by investing the transfer cash would make that time period even longer. There may be inheritance tax payable upon death if a transfer is made to a personal pension but, with financial advice, this tax can often be mitigated.
The great advantage offered by transferring DB to defined contribution (DC) is the flexibility it provides when drawing income in retirement. Typically people need more money to spend in the early years of retirement when they remain active. For some, this income is taxed at the higher income tax rate. With control and advice on the amount of income drawn down from say a SIPP platform, tax payable can be planned and reduced.
As people grow older, their need for cash generally reduces but financial planning dictates a lump sum should be planned that can be used to continue providing an income; to cover the two or three years of very high expenditure should residential care is needed; or to be left for the family. In the example above, if investment growth averaged 4% a year and a person drew the same income as they could have taken from the DB scheme there will be an amount of £74,000 left over at age 85.
Why then are more people not investigating the new options? There are three core obstacles:
* The Financial Conduct Authority (FCA) actively discourages it, which means many advisers avoid the issue.
* The cost of the advice that must be taken for schemes over £30,000 is expensive.
* A lot of people just do not realise these options are available – particularly as many thousands in DB schemes have never thought they need financial advice.
The last of these is probably the key reason, for which much blame lies with the trustees of the pension schemes who generally view transfers unfavourably – even if they are very often in the sponsoring employer’s interest.
Those trustees, of course, might reasonably respond that they have no duty to spell out to retiring members the options available. Yet the FCA has put rules in place for those who run personal pensions to ensure plan-holders are encouraged to shop around and so, if pension freedom is to be applied to everyone equally, surely something similar is needed in the DB world.
Nigel Chambers is managing director and co-founder of CTC Software