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Looking beyond the high valuation is crucial
Thursday 10 Aug 2017 Author: Tom Sieber

If you’re a member of a final salary pension scheme you might have received a tempting offer to cash in your benefits. There are a whole host of factors you should weigh up when deciding whether to take the plunge.

Why is the subject so topical?

The number of people choosing to transfer out of final salary pension schemes has been increasing since the pension freedom reforms were introduced in 2015.

The reforms have given savers much greater control over their defined contribution (DC) pensions. Instead of being forced to buy an annuity, you can access your pension pot at age 55 and choose whether to take a 25% lump sum, go into income drawdown, buy an annuity or a mixture of these routes.

AJ Bell’s head of platform marketing Mike Morrison explains why this is leading people to exit final salary pensions.

‘In April 2015, the introduction of the pension freedoms allowed people in defined contribution schemes a lot more flexibility in terms of how they access their pensions and how their pensions are distributed on death. The pension freedoms did not apply to defined benefit (DB) schemes, however, so many wanted to transfer their funds from their DB schemes to DC schemes in order to take advantage of the new freedoms.’

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Why are companies offering such high valuations?

The transfer values being offered by final salary schemes have increased significantly in recent years. The value can sometimes be more than 30 times the individual’s income, which is well above the historic average.

Charles Calkin, financial planner at James Hambro & Co, says this is because pension fund actuaries are heavily focused on meeting their liabilities. They want to know how long they will be responsible for paying a pension and what they need to put aside to fulfil that obligation.

‘This is largely based on the returns offered by Government bonds. When these are as low as they are now then the costs rise significantly, which has a knock-on effect on transfer values – the amount they’ll give you to take the liability off their books,’ explains Calkin.

The cost of providing DB pensions has also increased with the rise in longevity. Nowadays schemes are paying pensions for considerably longer than they used to do in the past.

Transfer values are calculated by the pension fund’s trustees. They are responsible for offering members fair value, taking into account the current economic circumstances.

What are the advantages of transferring?

There are lots of pros and cons of cashing in a DB pension, and the decision will depend on your individual circumstances.

Cashing in the pension would allow you to manage the pot yourself. You’d get greater flexibility over how much money you draw each year, which could help you manage your tax liabilities.

If you transfer to a flexi-access drawdown scheme, any money still in your pension pot when you die can be passed to your beneficiaries free of inheritance tax (IHT).

If you die before age 75 your beneficiaries can draw benefits tax-free. If you die over 75 your beneficiaries can draw benefits subject to their own income tax rate.

Calkin says this makes pensions a valuable IHT planning tool. ‘Many of our clients now draw on their non-tax-wrapped savings first and ISAs second, leaving their pension savings until later in life to help reduce any IHT liabilities on their estate,’ he says.

If you’re in poor health you might want to cash in your benefits so that you can make the most of them before you die. DB schemes tend to base annual income on a post-retirement life expectancy of 20 years.

Another factor that might encourage you to transfer is if you think the pension scheme is at the risk of becoming insolvent.

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What are the disadvantages of transferring?

A key benefit of a final salary pension scheme is it offers you a guaranteed income for the rest of your life. The income often increases in line with inflation. This can offer peace of mind, particularly for those who are risk-averse.

If you transfer to a flexi-access drawdown scheme you will be taking over the investment responsibility for what could be an enormous sum of money. That money may need to last for 30 to 40 years.

Most DB pension schemes enable your spouse to receive half or more of the pension income on your death for the rest of their life. The benefits may even extend to dependant children.

The regulator, the Financial Conduct Authority, says in most cases you are likely to be worse off if you transfer out of a DB scheme, even if your employer gives you an incentive to leave.

‘We agree with the FCA that the default position should be that you remain in the final salary pension scheme but there will be situations where it is worth considering transferring out,’ says Calkin.

Martin Hooper, associate at Barnett Waddingham, says some schemes let members take part of the benefits as a transfer value leaving behind a ‘core’ level of benefit in the scheme.

‘This allows the member to retain a level of guaranteed income whilst being able to make use of the more flexible regime for money purchase benefits with the remainder,’ he explains.

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Could my investment skills be better than a pension fund?

It’s possible for someone to have the skills to invest in a way that better suits their needs than the final salary pension scheme.

Hooper points out that a pension fund will be invested on a collective basis in order to provide a defined level of benefit.

‘An individual may be able to achieve a better outcome if they have different objectives, or are able to tolerate higher levels of risk,’ he says.

However, it’s unlikely you’ll be able to access as wide a range of investments as the pension fund and you’ll probably have to pay higher charges.

Alistair McQueen, head of savings and retirement at Zurich, says studies suggest most people in Britain aren’t confident about their investment skills and usually underestimate how long they’ll live.

He warns that looking after your pension is a constant responsibility and not a one-off act.

AJ Bell’s Morrison underlines this: ‘For many people, the pension fund is the biggest asset they will have, and it might need to last in excess of 30 years, providing resource not only for them but for their spouse and family as well.

‘The investor should therefore consider whether they are confident enough in their skills and risk levels when it comes to investing for such important long-term goals.’

How do I figure out if the transfer value is generous?

You could be offered a huge sum of money but it won’t necessarily be good value. Calkin suggests assessing the ‘hurdle rate’ of return your money would have to provide to generate the same return on offer in a final salary scheme.

Broadly, the higher the multiple of your annual pension, the lower the hurdle rate.

‘A 40x transfer gives 60% more capital than a 25x transfer and relatively reduces the transaction risk. A low hurdle rate might encourage you to take the deal, but the calculations and considerations make this a very complex question,’ says Calkin.

It would be wrong to try to divide the transfer value by your life expectancy. Hooper says life expectancy varies widely, for example across different locations and income groups. In addition, the transfer value will normally make allowance for survivors’ benefits and pension increases, which are not reflected in a simple life expectancy figure.

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How important is financial advice?

It is a legal requirement to obtain financial advice if the transfer value exceeds £30,000. Many pension companies require everyone to get advice, even if the value is less than £30,000.

Andrew Tully, pensions technical director at Retirement Advantage, says a key part of the advice process is working out the value of the benefits being given up and how that can be matched or exceeded in an alternative pension arrangement.

‘Pension transfers are an emotive subject with very considerable amounts being offered to many people,’ he says. ‘It’s crucial people look beyond that attractive monetary figure and consider the longer-term financial needs for them and their family – advisers will help people do this.’

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