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Guaranteed incomes: defined benefit pensions, annuities and the price of freedom and choice
If you were offered £1m today or £1,000 a week for the rest of your life, which would you choose?
This was the very real – and admittedly enviable – dilemma facing 18-year-old Canadian Charlie Lagarde when she won the lottery in March 2018. In the end, she sensibly went for the weekly income option (given her age it was a bit of a no-brainer).
Millions of savers are facing a similar decision as they approach retirement, albeit often with much smaller sums of money.
So what factors do you need to consider when you’re choosing between pension flexibility and the security of a guaranteed income such as an annuity or a defined benefit pension? This article addresses all the main points.
SHOULD I TRANSFER OUT OF A DEFINED BENEFIT PENSION?
Over the past few years thousands of savers with defined benefit pensions have opted for billions of pounds in cash today (to be invested in another pension scheme) rather than a secure income tomorrow.
Defined benefit schemes are expensive pensions to maintain for employers, hence why many companies are eager for employees to leave their schemes by offering generous lump sums.
If you’re thinking about doing the same and transferring out of a defined benefit pension, make sure you know both the value of what you’re giving up and the new risks you’ll be exposed to as a result.
WHAT ARE DEFINED BENEFIT PENSIONS?
Defined benefit pensions pay you a guaranteed income stream from a set date (usually referred to as your ‘normal pension age’).
The amount you receive will be based on how long you’ve been in the scheme, with members accruing pension rights for every year they work for the company and are a member of the scheme. These rights will normally be based on either your career average or final salary.
For example, someone in a final salary defined benefit scheme with 1/60th accruals will earn the right to 1/60th of their final salary for each year they are an active member of the scheme. If they had a final salary of £60,000 and accrued 20 years of pension rights, they would get £20,000 a year in income in retirement.
To give you an idea of how much this might be worth, it would not be unusual for an employer to offer £400,000 or more today for someone to give up the right to this level of retirement income in the future.
A big part of the value in defined benefit pensions comes through protections attached to the plan. Usually defined benefit members enjoy inflation proofing on their guaranteed pensions, meaning their income keeps pace with rising prices. In addition, their spouse will often receive at least 50% of their pension income after they die.
RISKS TO CONSIDER
For those who accept the offer of a cash lump sum today over a retirement income tomorrow, there are various new risks to consider.
Responsibility for ‘longevity risk’ – that is ensuring your fund lasts as long as you – will shift directly onto your shoulders. You will need to manage your withdrawals in a way that ensures you have enough money to live on both today and throughout your retirement.
Taking out too much, too soon could leave you short of money in later years, while you also risk being hit with an unnecessary tax bill as 75% of your withdrawals will be taxed in the same way as income. It often makes more sense to take a steady, regular income from your fund to minimise the tax you pay.
As well as having control over your income levels, you’ll also be able to pick and choose your investments. This means you’ll be exposed to the fluctuations of the stock market – so the value of your fund might go down as well as up.
If markets take a turn for the worse you might have to rein in your retirement spending. And while you can take as much or little risk as you want, most people will at the very least want their investments to at least keep pace with inflation.
CONSIDER THE COSTS
There will also be extra costs and charges for you to pay, including the administration of your pot and for fund management, which previously would have been borne by your employer as part of a defined benefit pension. Keeping these costs as low as possible is a crucial part of retirement investing.
That is not to say you shouldn’t transfer – this is a personal decision only you can make, based on conversations with your financial adviser. On that point, it is important to note that Government rules mandate anyone with a defined benefit pension worth £30,000 or more must take regulated advice before transferring.
FIVE POINTS TO CONSIDER BEFORE YOU TRANSFER OUT OF A DEFINED BENEFIT PENSION
There are a number of clear drivers for those choosing products like a SIPP (self-invested personal pension) over defined benefit pensions. However, you must weigh up the pros and cons of both pension types before making your final decision. Here are five important points to consider.
– Although defined benefit schemes are relatively safe (provided the employer responsible for paying your pension remains in business), they are also rigid. For many savers, a SIPP is attractive because it allows them to adjust their income levels to fit with their lifestyle and invest in a way that suits them.
– The rules around death benefits are extremely attractive for SIPP investors. While defined benefit schemes might provide a 50% spouse’s pension, SIPPs allow anyone who dies before age 75 to pass on their entire fund to their loved ones tax-free. If they die after age 75 their fund will be taxed in the same way as income.
– Those who are ill or have life limiting illnesses might be able to take a larger income after they have transferred – either through drawdown or by purchasing an enhanced annuity (we’ll come back to this later in this article) – than if they stayed in their defined benefit scheme. This is because with a shorter expected life span, larger payments can potentially look more sustainable.
– A defined benefit pension promise is only as strong as the company guaranteeing to pay it. With a number of notable company failures in recent times – including the likes of BHS and Carillion – many members are understandably nervous about the prospect of pension cuts if the company sponsoring their scheme does go under. But even in the worst circumstances the Pension Protection Fund (PPF) exists as a valuable safety net, meaning you should still receive something in retirement. Broadly speaking, if you have yet to start drawing your pension you’ll get 90% of its value as a retirement income from the PPF, while if you have already retired you’ll get 100%.
– You could also lose inflation protection if you leave a defined benefit pension. Those who have yet to retire with very large entitlements may have these capped. The level of this cap will depend on the age at which you are due to receive your pension benefits. For example, in 2019/20 the cap for a 65-year-old will be just over £40,000, while for a 60-year-old it is just under £35,000.
THE SIMPLE GUIDE TO ANNUITIES
Guaranteed retirement incomes are not just about defined benefit pensions. For those who have built up a retirement fund in a product such as a SIPP, there is the option of converting some or all of it into a guaranteed income for life by purchasing an annuity.
An annuity is similar in design to a defined benefit pension, except rather than an employer guaranteeing to pay a retirement income it is an insurance company taking responsibility. The other key difference is that things like inflation protection and spouse’s pensions are optional – so they can be bought, but at extra cost.
WHY BUY AN ANNUITY?
The primary drivers for buying an annuity are, unsurprisingly, similar to the reasons someone with a defined benefit pension would decide to remain in the scheme rather than transferring out.
The main benefit of an annuity is that it provides certainty of income. So if you want a steady stream of money throughout your retirement and don’t have the time or inclination to manage your own investments, an annuity could be a suitable option.
For example, a healthy 65-year-old with a £100,000 pension pot might be able to buy a single-life, inflation-protected annuity paying an income £3,478 of year.
If you’re considering going down this route make sure you get an individually underwritten annuity which takes account of any illnesses or lifestyle factors which might entitle you to a better rate. The difference between a ‘standard’ and ‘enhanced’ annuity rate can be 30% or more, potentially making an enormous difference to your quality of life in retirement.
It’s also absolutely vital you shop around because once you’ve bought an annuity, there’s no going back. Some investors opt to have some of their retirement savings in an annuity and the rest kept invested in the market via a pension.
A good place to start your research is Money Advice Service’s website which has various useful tools to see how much you might get.
You can buy annuities from companies such as life insurance providers or through a broker albeit the latter will take a commission which will be reflected in your quote.
HOW MUCH COULD I GET FROM AN ANNUITY?
A £200,000 pension pot could buy a healthy 55-year-old an inflation-protected income worth £4,391 a year.
A £300,000 pension pot could buy a 60-year-old who has smoked 20 cigarettes a day for 20 years, drinks 10 pints of lager a week and has both high blood pressure and high cholesterol an inflation-protected income worth £9,765 per year.
If a person of the same age and with same pension pot didn’t smoke, drink or have these health conditions the income would fall to £8,310 per year because they would be expected to live for longer.