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Kirk Rice Blog

Should I Transfer Out Of My Final Salary Pension Scheme?Written on May 16, 2019 by Kirk Rice LLP

Should I Transfer Out Of My Final Salary Pension Scheme?
Financial Services Questions

The Question:

Should I transfer my final salary pension scheme? My colleagues and friends have transferred their pensions and tell me it will enable them to do more in retirement than if they stay in the scheme.  Are they right?

Kirk Rice LLP answers:

In my experience many people who have been members of a final salary pension have paid relatively small contributions (typically nothing or up to 5% of salary) and been offered transfer values in excess of £500,000 which seems an awful lot of money. It is not uncommon to see transfer values that exceed £1m. With these sorts of numbers being available most people are naturally interested in the transfer opportunity. It’s also clear that most people we meet who have never had final salary pension schemes have not been able to accumulate anywhere near this amount of money in pensions.

It is likely to be in the best financial interests of most members to remain in their final salary pension scheme (in the tax and pensions world these are referred to as Defined Benefit or DB schemes). A DB scheme promises a pre-determined level of benefits that is underwritten by an employer. It is very unlikely the transfer value can be used to provide benefits of equal value to those given up.

There is no substitute for quality personal financial advice specific to your own particular circumstances. You should be able to determine if you need to consider advice about a transfer from the key advantages and disadvantages set out below. A Pension Transfer Specialist adviser will be able to recommend whether a transfer is suitable or not. A scheme will not allow you to transfer without advice if the transfer value is £30,000 or more.

Advantages of Final Salary Pension (Defined Benefit) Schemes

Never run out of money

The scheme must manage it’s assets to make payments to you for as long as you live AND if a dependant survives you most schemes will make payments for as long as they live too. Whatever income you start with will increase annually with inflation, although there are limits to how much protection you’ll receive and it’s rarely better than 5%pa.

Example:

If a member retired in 1990, on a starting pension of £5,000pa, they would now be receiving £11,610pa having been subject to an average inflation increase of 2.90%pa.  It will have paid out a total of £233,843 over the period.

Today a few schemes offer an alternative of a level income throughout, which for simplicity, based on the example might be say £8,300pa. This provides greater income at the start, but of course no inflationary increases. Note that the Scheme’s cash liability is the same, but will be decreasing over time and this reduces the need for long term funding from the employer. This option is not widely available on most Schemes.

Each final salary pension scheme sets it’s own inflation calculation subject to being at least as good as the minimum legal standards. Schemes can set more generous rules than the legal minimum and apply discretionary increases if a surplus exists.

All income paid to you is subject to income tax and is deducted by the scheme prior to making payments to you using the PAYE system. You are responsible for your PAYE code in order to make sure the correct amount of tax is paid.  It is extremely rare for a scheme to offer a large enough Transfer Value that you can buy matching benefits on the open annuity market.

Serious ill health

If before you start receiving a pension you are diagnosed terminally ill you can ask your scheme for a conversion of future payments (usually 5 years income) into a cash lump sum.

Death soon after starting the pension

The scheme will always pay the first 5 years income. That is if you and all of your dependants die within the first 5 years, the balance of income will be paid to your estate.

These above events are relatively rare and the reduction in future income liabilities will improve the financial strength of the Scheme and contribute to reducing employer liabilities.

Tax Free Cash

The scheme will calculate a maximum cash sum it will offer you immediately with a lower pension income for life. You can spend this money as you see fit and you do not pay income tax on it.

Pension Protection Fund (PPF)

If an employer becomes insolvent and therefore unable to continue to pay money into the Scheme the pension fund may become insufficient to meet it’s liabilities (paying all the promised incomes to members). In such cases the scheme’s assets pass into the Pension Protection Fund and your income will be paid from there.

For members who have passed the scheme’s retirement age the pension income will continue at the same value.

Investment Risks

You do not bear any consequences of falling investment markets, responsibility lies with the trustees to manage the assets to meet the needs of members and for the employer to add money when necessary.

Investment markets will show growth over the longer term, say 15 years or more, it reduces the amount the employer needs to contribute and could reduce the risk of moving to the PPF.

Charges

The scheme’s size means it can buy professional services at a lower cost than you will pay for investment, tax and management of a personal pension.

Lifetime Allowance

A scheme pension benefit uses less of your Lifetime Allowance than the transfer value might because of the calculation method. You are more likely to be subject to paying Lifetime Allowance tax charges if you transfer.

Example:

Scheme pension offered £30,000pa – if the member takes this they will crystallise 20 x £30,000 = £600,000 which is 57% of the Lifetime Allowance leaving the balance for any other pension schemes they may have.

The same scheme offers a Transfer Value of £900,000 and if this is crystallised immediately after transfer to a personal pension it uses 85% of the Lifetime Allowance.

Disadvantages of Final Salary Pension (Defined Benefit) Schemes

Single decision

You have to decide on tax free cash and income for a retirement period that could be more than 30 years long. The scheme will not allow you to vary the selection in retirement if your circumstances change.

Pension Protection Fund

Members who have not reached the scheme retirement age and anyone expecting a pension of more than £39,005pa should carefully consider the following disadvantages:

Members who have not reached the scheme retirement age will have their pension reduced by at least 10%.

Anyone who has retired early and is receiving a pension from the scheme, will have their early retirement pension recalculated by the Pension Protection Fund and the cut will be immediate.  The early retirement factors applied by the PPF could be different to the scheme and mean a reduction in your income.

If you have yet to retire or receive an early retirement pension when your scheme enters the Pension Protection Fund and the pension income exceeds £39,005pa the Pension Protection Fund will reduce your income to £35,106.

If your future pension is going to be subject to this cap, and you think your employer is going to be insolvent you need to act fast to make a transfer decision. Once the insolvency is announced or financial information suggests it is likely, you’ll not be able to transfer out of your scheme until the Pension Protection Fund has reviewed it’s viability. Not all final salary pension schemes progress to the Pension Protection Fund as they may have sufficient assets to meet their liabilities.

Inflation increases will be at the legal minimum standards which may prove to be less generous than the scheme had provided. This means no inflation rises for your accrued pension for membership periods prior to April 1997. All increases are capped at a maximum of 2.50%pa.

Tax free cash

Currently the factors in the calculations mean that after a transfer to a new personal pension you’ll be able to access a larger tax-free cash value (known as the Pension Commencement Lump Sum).

Example:

Scheme pension offered £30,000pa OR £90,000 cash (tax-free) and a pension of £22,500pa

After transferring the £900,000 (Cash Equivalent Transfer Value) to a personal pension up to £225,000 could be taken out immediately tax-free.

Inflexible income

A scheme pension cannot be suspended or varied to suit your circumstances and reduce the amount lost to tax. Some people have other income, particularly in the early years of retirement and are paying more than 20% income tax on some.

If you defer your retirement past the scheme’s normal pension age you cannot receive the income you missed. Your deferred pension will start at a higher value than at normal pension age, but it will generally take over 20 years for the total income paid out to match the pension payable from pension age.

Example:

Member pension at normal pension age in 1990 was £5,000pa.  Let’s assume the member delayed the pension until 1995 and the new starting pension offered was £6,400pa. (If they had started their pension in 1990 they would be receiving £5,950 after inflation increases), however, the deferred member has missed payments of approximately £27,200 over the 5 years.

Dependant’s benefits

If you will not have any dependant(s) in retirement then the scheme benefit is of no value to you.  You cannot choose non-dependant beneficiaries. The scheme calculates the group liability for pensions to dependants and this average is factored into your pension and adds to the transfer value.

Beneficiaries

If you transfer to a personal pension you can choose who you wish to share any pension money after your death.  They do not need to be dependants.

Serious ill health

After your pension income has started and you later suffer serious ill health, you cannot ask the scheme for an advance or increase in pension based on the fact you will not live as long as originally expected. Despite the fact you are going to die much earlier than expected, the scheme will not increase any dependant’s pension.

Death soon after starting the pension

The final salary pensions scheme only guarantees the first 5 years pension payments if you and all dependants die within that period.

If you invest your transfer value in a personal pension the remaining investment amount is available to your chosen beneficiaries. However, no one will receive a guaranteed pension income by default.

Investment risks

Investment portfolios have shown real growth over 15 years or more (retirement is a long term investment period) and effectively reduces the amount the employer needs to contribute. You cannot directly benefit from that growth.

Lifetime allowance

A scheme pension benefit is crystallised in a single event and will utilise any available Lifetime Allowance and create a tax charge where an excess exists. A personal pension can be taken in phased amounts and possibly delay the payment of any tax on the excess.

In most cases you are likely to be worse off if you transfer out of a final salary pension scheme. The cash value may be less than the value of the defined benefit payments to you and your eventual pension payments will depend on the performance of the new scheme, with the risk that the scheme does not deliver the returns that you expect.

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Any reader interested in discussing their own final salary pension scheme circumstances can call to 01344 875 000  to speak with one of our financial planners or email info@kirkrice.co.uk.

Please note: answers are given for general guidance only and specific advice should be taken before acting on any of the suggestions made. The information is based on current tax legislation which may change in future.

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