Posted on: 14th June 2018
Should you forgo your Defined Benefit (DB pension) and exchange your rights for a cash equivalent? That’s a question many people aged over 55 are asking since pension freedoms were introduced in 2015. However, how can you tell if this is the wisest choice? How do you know you’re making the right decision? Well, hope this two-part guide will go some way to answering those questions. In the first part of the article, we’ll look at 5 reasons why you might wish to consider transferring out of your DB .
Although DB pension rights may seem attractive, they do lack flexibility. A pension scheme may [provide benefits for the remaining spouses of married members after the death of the beneficiary, but that is no help to unmarried scheme members. However, if you converted your DB pension rights into cash and placed the money in a DC pension, you would benefit from the new pension freedoms and be able to use your cash resources more flexible.
The cash amount you’re offered generally reflects the average cost to the scheme of providing benefits to widows/widowers. So, as a single member, you will receive some value of the provisions you wouldn’t have done had you stayed in the scheme. Anyone over the age of 55 can now often access their DC pension pot as they wish, giving them more flexibility. So, if you wanted to retire at 60 and live off your savings you could do so with a DC pension. Had you stayed in the DB scheme, you may well have had to wait an extra five years to access your pension.
However, transferring money into a DC pension doesn’t guarantee the funds will last longer: in fact, if the valuation of the rights is calculated cautiously, you may actually lose some value when you transfer. So although you could take your pension earlier under a DC arrangement, you’ll be spreading the value of your pot over more years than had you waited longer under the DB arrangement.
After transferring from a DB to a DC pension you can choose how to spread your income and spending throughout, rather than receiving a rigid amount. With this greater flexibility, you may choose to spend more in earlier retirement whilst more mobile and spend less later.
Potential for Access to more Tax-free Cash
Whilst income from a private pension is subject to income tax, mostallow you to take one quarter in the form of tax-free cash. In a DB pension, this usually means you will get a cash lump sum at retirement, plus a lower regular pension. In a DC pension, you can usually take a quarter of your pension pot as a tax-free cash lump sum from the age of 55.
One major reason why transferring may prove attractive is the potential to draw more cash than had you remained in the DB scheme. If you remained in a DB scheme, you can generally give up a quarter of your pension rights in exchange for a tax-free lump sum. However, the value not always equates to a quarter of the value of your pension, as:
- Schemes have varying rules about how the pension you have given up is converted into an equivalent lump sum, and some schemes can be less than generous in this regard.
- The process of converting from a regular pension to a lump sum is based on the scheme member’s pension only. The rights are given up, however, include a potential pension for a widow/widower.
- Complex tax rules mean that the size of the lump sum is reduced relative to the amount of pension given up.
If you were to convert some of your pension into a lump sum, it is worthwhile considering how long you are likely to live. If you expect to live for 20 years after retirement and are giving up a pension of £3,000 a year: you would receive £60,000 in pension (excluding effects of inflation) over the next 20 years. If the DB scheme offers you less than £60,000, the deal may not be so attractive.
Alternatively, you could transfer your entire DB pension rights into a DC arrangement. Once the money is in a DC arrangement (assuming you’re aged 55 or over) you can then take a quarter of the whole pot – a figure likely to be higher than under a DB arrangement – as a tax-free lump sum. So, if tax-free cash is important to you, there may be some advantages in transferring out, particularly if your DB scheme is one which offers ungenerous tax-free lump sums within the scheme.
The ultimate decision about whether or not to stay in your DB scheme may depend on who will be left behind after your death and how much you wish to support them financially. Recent changes in rules on inheritance tax on certain types of pensions have made it more attractive to consider having your pension rights outside the DB scheme.
If you remain with your current pension scheme, there may be a pension for your widow/widower when you die. If you die early (perhaps only a few years into receiving your pension), your widow/widower may benefit from a guarantee period where the full pension must be paid for a minimum of (say) five years.
If you’re part of a couple but not married, those rights may be limited, but this will vary from scheme to scheme and may be at the discretion of the scheme trustees. There may also be some pension entitlement to any surviving dependants such as children of school age.
Whilst such provision is welcome and valuable, it does mean that in many cases when you (and perhaps your widow/widower) die, your pension will die with you, and there will be then be nothing left to pass on to your heirs and successors.
One alternative is to convert your DB pension rights into cash and then transfer it into a pension (if you’re still saving) or a drawdown arrangement. In this case, the value and assets in the pension orcould pass on to your heirs if you die. However, it’s worth bearing in mind the tax treatment of such money. Under recent changes, if you die before the age of 75, the cash balance left behind can be received by your successors completely tax-free.
Even if you were to die over the age of 75, whoever inherits your pot will only pay income tax in the usual way when they make withdrawals. Furthermore, if your successors don’t draw on this inheritance, it can then be passed on to subsequent generations. However, present or future governments could change the rules on the tax treatment of pensions at any time should they chose to do so.
One advantage of a DB pension is that it lasts for your lifetime. However, what about people with a low life expectancy? If you were to retire at 65 and then die at 71, you wouldn’t get back anything like as much value from your pension as those who live until their nineties.
The reason for this is that DB pension schemes work by pooling risk. This pooling benefits those who live longest and is subsided by those who live the shortest. If you think your life expectancy is below average, then you might consider a transfer. The value you are offered should broadly reflect the average life expectancy and may give you more money than the amount you would have received had you stayed in the DB pension but died early.
In such circumstances, you could invest the money so that your heirs receive the cash when you die. Alternatively, if leaving behind a legacy is not a priority, you could buy an enhanced annuity. This is an income for life, but one which takes some account of your likelihood of dying early.
Worries about the solvency of the sponsoring employer
If the employer who sponsors your final salary pension scheme is at risk of becoming insolvent, then there is a chance that you might not get all of the pension you expected. If you transfer out, however, your will be unaffected by what subsequently happens to your ex-employers business.
Under existing rules, if the business sponsoring the DB pension scheme becomes insolvent, and does not have the money to honour all future pension commitments, then the scheme will be transferred into an insurance-type lifeboat arrangement called the Pension Protection Fund (PPF).
Under the rules of the PPF, those who have already reached normal pension age by the time of the insolvency will get their full pension paid by the PPF, whilst those under the scheme’s pension age will get 90 per cent. What matters is your age relative to the scheme’s pension age and not whether or not you have retired.
If you are unsure whether transferring out of your DB pension scheme is the right choice for you, and would like objective advice, then talk to Haven IFA. Our team of professional advisors are here to help you save for retirement in a way that works best with your lifestyle. Contact us for more information.