Before I dive into this, DB pensions are known as gold plated because they aren’t a pension that gets handed out easily anymore unless you are employed in the civil service and I write this because clients have asked me about transferring DB pensions. A quick story:
I have a client who didn’t need the pension, they were financially free or independent, whichever term you prefer, and this DB pension was small compared to what they had. They wanted to transfer out so they could utilise the pension in other ways, we went through the process of getting a CETV (they play hardball with these as they are time-sensitive no matter how many times you call), signing the appropriate forms for me to act on their behalf and all the rest.
After a lot of chasing, nagging, and asking for a value, we got one and had a report produced, which cost a few thousand. Can you guess the answer? It’s not recommended to transfer this pension. We could have spent much more time appealing, producing another report, and all the rest in between.
After a frustrating few months, the pension was left where it was. This was several years ago and this is happening because many advisors were taking these DB pensions which had significantly more amounts in them and putting them into investments that were in the advisor’s interest (commission) and leaving the investor potentially out of pocket or an investment that wasn’t right.
To labour the point, I have a family member with a 3k DB pension and they must seek financial advice before transferring.
If you have any questions, please contact me using the button at the bottom of the page.
What is a DB Pension
A defined benefit pension is a retirement plan in which workers, typically employed by private firms, contribute to a company pension fund, and in return, they are promised a guaranteed retirement income. The benefits under this type of pension plan are predetermined and are based on factors such as the length of time the employee has worked for the company and their salary.
Defined benefit pensions are so named because the specific benefits that retirees will receive are defined by a set of rules established by the pension scheme. These rules typically include four fundamental rights:
- Lifetime Guarantee: Retirees are assured that their pension payments will continue for the entirety of their lifetime, ensuring they do not run out of money during retirement.
- Survivor Benefits: In the event of the pension holder’s death, their surviving spouse is usually entitled to receive a portion of the pension payments, often around half of the amount the worker was receiving.
- Cost-of-Living Increases: To protect the purchasing power of the pension income, defined benefit pensions often include provisions for periodic increases in payments to keep pace with inflation.
- Payment Stability: Regardless of how the stock market or other fund investments perform, the level of pension payments remains consistent and is not dependent on the investment’s performance.
In contrast, defined contribution (DC) pensions operate differently. They rarely offer guarantees, with the exception of some older schemes that may have a guaranteed annuity rate, which is becoming increasingly uncommon. DC pensions are based on the value of the pension fund, and the retirement income can fluctuate depending on how the investments within the fund perform. Many modern company pensions have shifted towards DC schemes because employers find them to be a more cost-effective alternative to providing the guarantees associated with defined benefit pensions.
Why Savers Consider Transferring Out of a Defined Benefit (DB) Pension
Pension savers often contemplate transferring out of a DB pension for a variety of reasons, which can typically be distilled into five key factors:
- Increased Flexibility: DB pensions come with a predetermined retirement age, and early retirement options are usually less generous. The pension scheme’s standard retirement age often hovers around 60 years old, with some even aligning with the state pension age (e.g., 66 or older) for the individual’s age group. In contrast, most DC schemes now grant savers the option to access some or all of their retirement savings from the age of 55, providing greater flexibility in retirement planning.
- Tax-Free Lump Sum: Both DB and DC pensions adhere to the same tax rules, allowing savers to receive a 25% tax-free lump sum. However, in the case of a DB scheme, the tax-free amount can be less than 25% due to the specific calculation method employed, making DC pensions potentially more tax-efficient in this regard.
- Mitigating Employer Solvency Concerns: Recent instances of large employers facing financial difficulties or insolvency have prompted concerns among pension savers. While the Pension Protection Fund (PPF) aims to maintain pension payments at the same rate as the employer, new retirees may see reductions in their benefits. In response, many workers opt for a DB transfer to safeguard the value of their pensions, reducing reliance on the employer’s financial stability.
- Health Considerations: DB pensions operate on a risk-sharing model, where individuals with shorter lifespans essentially subsidize those with longer life expectancies. For individuals in poor health, transferring out of a DB pension can help protect the level of their pension income, ensuring it aligns better with their specific needs.
- Spousal Considerations: DC pension rules often enable relatives to inherit unspent pension funds, making them an attractive option for some couples, especially those who are not married. By transferring out of a DB scheme, the pension can be left in its entirety to the surviving partner, regardless of marital status. In contrast, DB pensions may not offer the same inheritance opportunities, as the pension fund typically ceases upon the death of the surviving spouse, while a DC fund can potentially be passed on to subsequent generations.
Understanding the Rules Governing DB Pension Transfers
The Financial Conduct Authority (FCA), the government’s regulatory body overseeing the pensions advice industry, provides clear guidance regarding DB pension transfers:
- Staying in a DB Pension is Often in Your Best Interest: According to the FCA, for most retirement savers, the optimal financial choice is to retain their DB pension benefits.
- Suitable and Appropriate Advice: Should someone contemplate a DB pension transfer, the FCA mandates that firms offer advice that is suitable and tailored to the individual’s specific needs and circumstances.
Two additional factors influencing the eligibility for a transfer are that savers cannot proceed with a transfer if they are within 12 months of the scheme’s retirement age or if the scheme is administered by the Pension Protection Fund.
Why DB Pension Transfers Tend to Yield Negative Outcomes
When financial advisers conduct an analysis of a DB pension transfer, they primarily assess risk. Some advisers argue that the comparison methodology mandated by the FCA tends to skew results in favor of a negative outcome for DB transfers.
To ensure fairness in DB analysis, the FCA requires all advisers to adhere to a consistent framework, allowing savers to easily evaluate the pros and cons of various schemes.
Traditionally, the critical yield figure played a central role in these assessments. The critical yield represents the annual investment return required from the new pension to replicate the benefits offered by the DB scheme.
The FCA has updated its guidelines for such analyses, which still involve critical yield but now extend to a more comprehensive evaluation of the expected rates of return on each asset or fund within the pension portfolio. Often, these rates are quite low or even negative, contributing to the tendency for negative DB transfer reports.
Advisers emphasize that investment funds inherently carry some level of risk, and as savers incur costs associated with a DB transfer, reducing the fund’s value, it’s almost inevitable that the DB transfer analysis will recommend against transferring.
Additionally, due to persistently low or negative gilt yields, more funds are required to secure an equivalent income. Therefore, for those seeking guaranteed or increasing retirement income, transferring out of a DB scheme may not be advisable.
Summary
In summary, the typical outcome of a DB transfer analysis is a recommendation against switching schemes, largely driven by the complex interplay of factors and the challenges associated with replicating the security and benefits of a DB pension in alternative arrangements.
As an expat with a DB pension, if you have any questions, please contact me using the button at the bottom of the page.
Other articles that might interest you:
- How the March 2023 U.K. Budget Affects Your Pension
- Defined Benefit or Final Salary Pensions
- Red Flags for UK Pension Transfers
