With a Defined Benefit (DB pension scheme, the amount of pension you will receive upon retirement is based on how long you worked for your employer and the salary you earned.
A DB pension has several advantages. Firstly, the pension will last for the rest of the scheme holder’s life so they won’t need to worry that there is an end date for which they can draw a pension. Secondly, should they pass away there will be income for their widow or widower. Generally speaking, a bereaved spouse will receive 50% of the pension for the rest of their life. Third, there is some protection against inflation, so the pension’s spending power will be maintained. Lastly, a DB pension won’t be affected by the stock market.
Despite these compelling advantages, there are some disadvantages to having a DB pension. Many scheme members feel that it is too restrictive, with a lack of choice as to how and when to take their pension.
There is a second option open to those looking for more flexibility. A growing number of people are considering changing their DB pension rights for a cash equivalent, known as a Defined Contribution (DC) scheme transfer. In fact, a growing number of people are being offered huge cash sums in exchange for giving up their rights in their DB pension scheme. It’s worth noting that once a DB to DC transfer has been made it is irrevocable, so it’s not a decision to be taken lightly.
The main advantage of giving up rights to a DB pension is flexibility. While a DB pension can be very valuable, it can be inflexible. There will be a set pension age, which cannot be altered, and drawing a pension before this time could be financially unfavourable.
The health and likelihood of how long a person is likely to live are also major considerations.
If due to lifestyle, the general state of health or family medical history, a person is likely to pass away early, they may want to consider opting for the cash alternative. The value offered should (broadly) reflect average life expectancy.
For example, if someone was expected to live for 20 years beyond retirement age and is giving up a pension income of £500 (£6,000 per year) over the next 20 years they would receive £120,000 (excluding inflation). Therefore if the DB scheme offers a cash sum of less than £120,000, they may decide to remain in the current pension scheme. DB pension schemes work by pooling risk, and in effect, those who live for the longest time are subsidised by those who live for the shortest time.
If they withdrew the entire DB pension rights and transferred them to a DC arrangement, they could take 25% of the whole pot as a tax-free lump sum which is likely to be a larger figure than if it remained in the DB arrangement.
If a pension scheme offers an unfavourable tax-free lump sum within its scheme rules, there may be advantages of transferring out.
Inheritance is also an advantage of taking a cash alternative. While a DB pension scheme will have generous terms for a widowed spouse (and there may even be some pension entitlement to surviving dependents such as children of school age), if the pension holder is unmarried it will be of no value to the bereaved partner, even if they had been cohabiting. Therefore a pension holder may wish to make a decision based on who will be left behind in the event of their death and how much they want to support them financially.
Recent changes in the tax rules on inheritance of certain sorts of pensions have made it more attractive to consider having pension rights outside of the existing DB scheme.
By remaining in a DB pension scheme, it means that the pension will die with the scheme holder and subsequently the remaining spouse, with nothing left to pass to successors. By converting the DB pension rights into cash, it can be invested in assets that can be left to successors. It can also be transferred into a pension or a drawdown arrangement. However, tax implications need to be carefully considered.
If the DB pension scheme holder is unconcerned about leaving anything behind after they are gone, they could buy an enhanced annuity. This will provide an income for life but will take into account the likelihood of dying. For example, if they smoke or drink heavily or have a serious medical condition they will be able to get a relatively generous annuity rate because the annuity provider does not expect to be paying the annuity for very long. It’s worth obtaining a transfer value quotation from the current scheme and then finding out what annuity they might be able to buy before actually making the transfer.
As mentioned above, a DB pension scheme holder cannot change their mind once they have transferred to a DB to DC pension. Similarly, once they have started to receive benefits from your DB pension, it cannot subsequently be transferred for a cash alternative.
There are some types of DB pension schemes that will not allow a cash transfer. These apply mainly to public sector pension schemes because they are unfunded.
For some, the arguments in favour of transferring out of an existing DB pension scheme may be particularly compelling if they:
- Want to maximise their tax-free cash;
- Don’t believe that they will live long into their retirement years;
- Are thinking about passing on their pension to a spouse after they die;
- Are willing and able to take on the investment risk associated with their pension; and
- Are concerned that their pension holder might not be there in years to come.
On the other hand, those who value the certainty offered by a DB pension may be advised to stay put, for example, if they:
- Feel that they have a high life expectancy and want a pension to last as long as they do;
- Want a measure of insulation against inflation;
- Want the peace of mind that they are less likely to breach tax relief limits;
- Don’t want to worry about fluctuations in the financial markets; and
- Want their pension to pass on to their spouse when they are gone.
Due to the attractive benefits of remaining in a DB pension, the Financial Conduct Authority informs financial advisers that they must start with the assumption that it is in the pension holder’s interest to remain in their existing DB pension. That’s why it’s imperative that a decision is made only once they have consulted with a qualified pension transfer specialist who can take account of their client’s circumstances and preferences. In fact, the law requires that if you wish to transfer a DB pension pot valued at £30,000 or more, they must seek financial advice before doing so, and rightly so. These are valuable pension rights that cannot be given up lightly. A decision of this magnitude must be made on an informed basis, and few people have the expertise required to make that judgment.