Defined Benefit Transfers
14th March 2016
Many employees have, over their working life, built up a considerable entitlement to a defined benefit pension. This type of pension undertakes to pay a predetermined portion of an employee’s final salary in retirement (hence these schemes are often called ‘final salary’ schemes). However, drawing an annual pension is not the only way to benefit from these schemes, and indeed it may not be the best way in light of recent changes in taxation and pension regulation.
It is possible to transfer out of defined benefit pension funds, receiving a lump sum (known as the ‘transfer value’) into a personal pension. The value of the pension as a lump sum is calculated on a prescribed basis which is complicated (it involves revaluing the pension to the expected retirement date, working out the capital value required to buy that income and then adjusting that capital sum to its present day value). In essence the value is closely linked to annuity rates. Because annuity rates are very low at present, the transfer values on offer are high.
By transferring out, it is possible to unlock several opportunities. First, as annuity rates are low compared to both current and historic market returns it is possible to invest the lump sum received in the transfer and potentially provide a larger income in retirement than would be provided by the defined benefit scheme. For example, a defined benefit pension may provide an annual pension of only about 2.5% of the transfer value. In contrast, a transfer value invested in the market could provide a return of 5% or more, all of which may be withdrawn as income.
Secondly, if the invested funds are carefully managed during retirement it is likely that some of the funds will remain on death. This creates a fund which can be passed on free of inheritance tax. Looking again at the example in the previous paragraph, by limiting withdrawals to the annual return of 5%, the capital may remain undiminished and can be left on death to a beneficiary. This contrasts with a defined benefit scheme which will not leave a fund on death, albeit a spouse’s pension, typically of 50%, will usually be provided if there is a marriage or civil partnership.
Thirdly, by transferring out of a defined benefit scheme, it is possible to access the new pension freedoms. A defined benefit pension provides little flexibility. Once started, it will pay a prescribed amount at a prescribed time until death. For some this regularity will be reassuring. However, many will find it restrictive. The pension freedoms mean that pensions can now accommodate changing circumstances and preferences. For example, an individual may wish to semi-retire, undertaking part-time work, before full retirement: this might require gradually increasing pension income. There may be tax planning opportunities, using the tax free cash to supplement income while still working. Alternatively a lump sum may be drawn (for example to pay off a mortgage) then nothing for some time before taking an income. These options are possible after transferring out, but not while remaining in a defined benefit scheme.
In conclusion, now is a good time to review your defined benefit pension scheme. It may be possible to achieve a greater, more flexible income and leave more to your loved ones by transferring out.
Cantab Asset Management reviews defined benefit pensions and is authorized to conduct defined benefit transfers.