Years ago, people who worked for big firms built up a company pension based on how long they had worked for the firm and how much they earned. In these much simpler days, beyond a certain point, people didn’t have to think much about their pensions. The pension they would receive was guaranteed by the rules of the pension scheme and was set in stone from the moment they retired. These are known as defined benefit pension (DB) schemes.
Nowadays, these are pretty rare. In fact, just 19 FTSE 100 companies still provide them. This is because they, on average, cost three times as much as they did 30 years ago due to people living longer in retirement and changing market conditions. Defined contribution (DC) schemes are the norm. In DC schemes, an employee contributes to their own pension alongside a possible input from their employer, depending on the conditions of their pension.
DB schemes are better suited to some people and DC schemes to others. The right decision depends on their personal circumstances and the nature of what their current or former employer offers them.
However, there are some clear benefits and drawbacks to each, which we thought we’d share with you:
Advantages of transferring out of your DB pension
- Transferring out gives you more flexibility. For instance, if you have a DB scheme with a set pension age, taking an early pension - if you are able to do so - may mean that your pension benefits will be lower. You may also wish to start your pension income at a higher level than the DB scheme to match your anticipated spending pattern, which may be higher in the first few years of retirement than later in life. By transferring, you can take control of how and when you take the benefits.
- Potential for more tax-free cash. Most DC pensions let you take 25% of the value of the pension as a tax-free lump sum, from the age of 55 onwards. Although the same goes for some DB pension schemes, for various reasons the amount often ends up as less. These include the fact that DB schemes have different rules around the calculation of tax free lump sums at retirement and those complex rules can mean that the size of the lump sum is reduced relative to the amount of pension given up.
- Inheritance. If you die and leave behind loved ones who aren’t included in the DB scheme, say an unmarried partner or grown up children, they are unlikely to receive anything from your pension. Recent changes to tax rules on certain sorts of pensions have made it more attractive to think about having your pension rights outside your existing DB scheme. If you transfer out into a pension or drawdown arrangement, the value of the pension could pass on to your heirs tax free when you die. Before making a decision based on these inheritance rules, be aware that the government could change the tax rules on inheritance pensions at any time.
- More pension if you die younger. If you think, for whatever reason, that your life expectancy might be on the short side, you might not get as much out of your DB scheme as you would by transferring out. Someone who dies in their late 60s in a DB scheme will receive considerably less than somebody who lives into their 90s. Like annuity companies, DB pension schemes operate by pooling risk. People who die younger effectively subsidise the pensions of those who live longer. Therefore if ill health is a factor for you, transferring out is likely to provide more income than you’ll receive from a DB scheme.
- What happens to your ex-employer’s business no longer affects you. When you receive a DB pension, there’s a risk that your old employer could face insolvency and you might not get all the pension you were expecting. Although, in the case of insolvency, some of your pension will be covered by a government insurance type arrangement called the Pension Protection Fund. Those who are under PPF will find the income they get from the DB scheme will in most cases reduce or not increase in line with inflation.
Disadvantages of transferring out of your DB pension
- Certainty over your future. DB pensions last as long as you do. If you live much longer than average, it is up to the scheme to find the money for you. Because you are guaranteed a fixed income, you won’t need to worry about spending your income too quickly.
- Inflation. We’re currently living in a time of (relatively) stable inflation. However, over a retirement that could last more than 30 years, this is liable to change. The extent of protection against inflation depends on the rules of your personal DB scheme. Although some inflation protection is likely to be factored into the cash transfer value you’re offered, after you accept the sum all of the inflation risk falls to you.
- Investment risk. In DB pension schemes the money is generally spread over a range of different assets, including shares, bonds, property, infrastructure, assets, commodities and so forth. However, whether these assets fall or rise you still receive the same amount of pension. This is not the case if you transfer out. If you invest your pension and its value falls, you’re the person who loses out.
- Providing for your loved ones. If you receive a DB pension scheme and you die either before reaching the scheme pension age or after, it's likely that your surviving spouse will receive a proportion of your pension. Most schemes outline that dependants are liable to receive your pension income after you die. Exactly who is a dependant depends upon the Scheme Rules and may also involve the Trustees who can have discretionary powers.
- Taxation. With most DB schemes, you must take the benefits all at the same time. Therefore if you have a larger pension, your benefits may be valued over the Life Time Allowance (LTA) threshold and at that point you would attract additional tax charges possibly up to 55%. Your pension scheme might decide to pay the tax on your behalf and recover it from you by reducing your pension accordingly. The LTA threshold would be something you would need to seek advice on if you transferred away from your DB Scheme, as you are more likely to reach it. It’s important to note that the LTA still applies to DC pensions.
While the benefits of staying in a DB pension scheme may appeal to some and, likewise, the prospect of transferring out may have some compelling advantages for others, one thing is true for everyone. Financial advice is essential before transferring out. In fact, if your pension is worth more than £30,000, it’s the law.
At Bailey Richards, we are experts in providing advice to people who have been offered the opportunity to transfer out of their DB pension scheme. Drop us a line. We can help.