Certainty
The principal advantage of a DB pension is that the benefits last as long as you. If you happen to live longer than average, then it’s up to the scheme to find the money to pay for this. Transferring your DB pension rights into cash and managing it yourself will create uncertainty as you have no idea how long you will live. There is clear evidence that people underestimate their life expectancy and, therefore, there is a chance you’ll run out of money prematurely.
However, there is also the concern of being so worried about running out of money that you’ll draw it out too slowly and lose out on the benefits of your savings. This could, of course, be overcome by buying an income for life (an annuity), but there are reasons to suggest this won’t be as good as the pension you’ve given up in your DB pension scheme. If all you are looking for is a guaranteed income for life, then you would probably be better served to stay in your DB pension scheme. It is more likely that you will go on investing your money and drawing an income from your fund.
The big question is, how quickly and safely can you withdraw money? Of course, there are things you can do to manage the risk. For example, you can speak to a financial adviser. An IFA can help review your current investments and withdrawal rate and make the necessary adjustments if you are taking too much out of your pot too quickly.
Whether you’re concerned about running out of money, or about being overly cautious about the rate of withdrawal, it’s important to understand these are not problems you would have had, had you remained within the DB scheme.
Inflation
With historically low inflation over the last 10 years, it’s easy to overlook the fact that over the retirement of 20 to 30 years, the value of having an income which comes with some protection against rising prices could be considerable.
The extent of protection against inflation which you enjoy will depend on the rules of your DB scheme and when you joined the scheme. To demonstrate how critically important inflation protection is, let’s assume that inflation runs at 2 per cent a year and that you’re DB pension rights are guaranteed to rise by this amount and that your retirement will last 20 years. If your starting retirement was £100 a week, it would be £148.59 by the end of your retirement. Without inflation protection, you would still receive £100 a week – a final pension nearly a third lower.
Clearly, the cash transfer value you are offered will reflect the value of the inflation protection built into your pension scheme. However, once the cash is taken, the risk of inflation will fall on you.
If for example, inflation was to reach 4 per cent then your DB pension scheme would rise by at least 2.5 per cent. Therefore, the real year-on-year fall in the value of your pension would only be around 1.5 per cent. With a DC pension pot, however, a 4 per cent rise in the price of goods means a 4 per cent fall in your standard of living.
Although it is feasible to ensure against rising prices by, for example, turning your pension pot into an inflation-linked annuity, this is likely to be a very poor value compared to your DB pension. A DB pension scheme is designed to make a more cost-effective provision against the risk of inflation than an individual can achieve by buying an index-linked annuity. If you do invest your DC pension successfully, however, you might achieve an above-inflation rate of return. The protection against inflation, however, isn’t guaranteed in the same way as in a DB scheme.
Investment Risk
When you are a member of a DB pension scheme, your money tends to be invested in a broad range of assets – from shares, bonds and commodities to property and infrastructure assets. The value of these investments, of course, fluctuates. However, when you’re a member of a DB pension scheme, the fluctuations of these investments will make no difference to how much pension you receive. The scheme must still pay your pension and the employer must bear the investment risk. In effect, you are insulated against the changes in investments.
If you do take a cash transfer and invest the money yourself, your fund value can (and will) fluctuate. This could work in your favour as your assets may perform quite well, but they could also perform badly, leaving you with a reduced income.
It is, therefore, a key consideration to consider your attitude to risk. If the majority of your non-state pension rights are vested in your DB scheme and you convert them into an investment then you could be taking a big risk. You must consider how you’d feel and how you’d cope if your investments fared badly.
There are, of course, ways to reduce the risk associated with investing in a DC pension or a drawdown product. When transferring out of a DB pension, you are shouldering your employer’s risks yourself. You should also bear in mind the additional costs incurred when managing a DC pot: these include the costs of initial and ongoing advice, as well as product fees and charges – costs that wouldn’t arise in a DB scheme.
Provision for Survivors
DB pension schemes have a legal duty to provide a pension for a surviving widow/widower if the scheme member dies after the scheme pension age. Many schemes offer benefits for widows, dependent children etc beyond the legal minimum. This is a valuable benefit which shouldn’t be disregarded lightly. There will also be some rights for widows/widowers under the rules around Guaranteed Minimum Pensions (GMPs) which many schemes must provide.
Of course, a cash offer made to a scheme member will in some ways reflect the fact that the scheme offers benefits to survivors. But as not all members will be married or have dependents, the cash value offered will often only reflect the average value of such benefits across all scheme members, including those with no survivor benefits.
It is possible to turn your money into an income for life with an income for your surviving partner when you die. DB pension schemes though generally offer such benefits in a more economical way than an individual annuity purchaser is able to. Moreover, depending on your surviving spouse’s circumstances, they may prefer the certainty of a DB scheme pension, rather than having the responsibility of managing a DC pension pot.
Taxation
For those with larger pension entitlements, the relatively generous tax treatment of DB pension schemes is another reason for careful consideration before transferring out of the scheme. Under current tax rules, you can build pension rights worth up to £1.073 million (2022) over the course of your lifetime. If you go beyond this point, you can face tax penalties.
For DC schemes, consideration needs to be given to the total amount in the pot relative to the £1.073 million lifetime limit (2022). For DB schemes, a more generous process applies. The amount of pension to be paid is multiplied by 2- and any tax-free lump sum is then added. The result is then tested against the LTA threshold.
There could be instances where a pension left in a DB scheme could be under the tax limit, but the DC equivalent could be over: for example, someone with a DB pension at 65 worth £40,000 a year who doesn’t take a tax-free lump sum. Multiplying this figure by 20 gives a total of £800,000 which is comfortably within the limit. If the scheme member instead requests a cash equivalent transfer value: the low level of interest rates, and the terms of the pension, may result in a multiplier of 30 being applied and a CETV of £1.2 million being offered. The member is now potentially at risk of a tax charge.
Clearly, in this case, they have been offered quite a large cash sum and the fact that the transfer would lead to a tax charge isn’t on its own a reason not to proceed. It does mean, however, that having a larger value pension pot could result in tax consequences, and that should be taken into account.
Summary
If you are wondering what to do with a DB pension, then it’s not always best practice to transfer it out. I have personally come across some cases where people have been wealthy enough (several million) to not need the DB pension, however, the report still stated that they couldn’t transfer out.
For many, it good sense to leave the pension in and take the benefits and the reasons above support this notion. Unless you are wealthy enough to not need the DB pension then it is worth heavily reviewing before you put in for a report because they aren’t cheap and it will mostly come back that you shouldn’t transfer anyway with regulations!
This isn’t financial advice, if you do need personal advice, you can email me or please find a qualified financial advisor. You can email me at info@investmentsforexpats.com
