I have a couple of old defined benefit pensions from previous employers. These are deferred as I’m not yet at retirement age. I have noticed on my recent statements the cash equivalent transfer value has dropped significantly (although the payments in retirement remain). Can you please explain how the relationship between interest rates and gilt yields influences pension transfer values? On the basis the yearly amount paid out by these pensions hasn’t diminished, is there any reason to be concerned?

Jonathan

Tom Selby, AJ Bell Head of Retirement Policy, says:

Defined benefit pensions promise to pay an income for life from a set age (your ‘normal retirement age’) that increases in line with inflation. The starting income is usually based on the number of years you have been a member of the scheme and your salary (either career average or final).

By contrast, defined contribution pensions are a pot of money you build up during your working life, with the responsibility for turning that pot of money into an income in retirement resting with you. This includes having the flexibility to take a retirement income to suit your needs from age 55 (rising to 57 in 2028) while keeping your fund invested through drawdown.

If you have a funded defined benefit pension (where the scheme holds assets to pay the promised pensions) and have yet to start receiving an income, you will be entitled to a cash equivalent transfer value.

WHAT DOES CASH EQUIVALENT TRANSFER VALUE MEAN?

This is the amount you would receive if you swapped your promised defined benefit pension income for a defined contribution pot of money.

If you are a member of an unfunded public sector defined benefit pension scheme (where the scheme doesn’t hold any assets, with the promised pensions instead paid out of general taxation), you are not allowed to transfer out.

Your cash equivalent transfer value will be based on the expected cost of providing your pension income. In the jargon, the scheme’s assessment of the value of all defined benefit income promises made to members will make up its liabilities, with investments in assets to pay these liabilities on the other side of the balance sheet.

The difference between assets and liabilities determines whether a defined benefit scheme is in surplus (assets valued higher than liabilities) or deficit (assets valued lower than liabilities).

WHY DO GILT YIELDS MATTER TO CERTAIN PENSIONS?

The cost of providing your pension is closely correlated to movements in UK government gilt yields (i.e., the interest rate on government bonds). This is because defined benefit schemes invest in gilts to pay the incomes they have promised to members.

When yields go down there is less money coming into the scheme to pay its liabilities. Similarly, when gilt yields go up, there is more money coming in to pay out to pensioner members.

That means when gilt yields drop, the scheme needs to use more of its assets to meet its liabilities. As a result, when gilt yields drop, cash equivalent transfer values offered to members will go up – the scheme can afford to pay more as the cost of you staying in the scheme and it having to provide your benefits is higher. Conversely, when gilt yields rise – as they have recently – the cash equivalent transfer value will drop as less assets need to be used to provide your pension benefits.

None of this affects your entitlement to a retirement income – it’s just the way defined benefit accounting works in relation to liabilities.

DO I NEED TO GET FINANCIAL ADVICE TO TRANSFER A PENSION?

For anyone considering transferring a defined benefit pension with a cash equivalent transfer value of £30,000 or more, you will need to take regulated financial advice before transferring.

While I appreciate it might be frustrating to have to take regulated advice before moving your pension, the requirement is in place for a reason.

Defined benefit pensions are extremely valuable and, although there are circumstances where a transfer can be in someone’s best interests, transferring is a decision that shouldn’t be taken lightly.

If you’re struggling to find an adviser, this Moneyhelper directory is a good place to start. It’s also worth noting that most defined contribution pension providers now require a positive recommendation from your adviser before accepting a defined benefit transfer.

DO YOU HAVE A QUESTION ON RETIREMENT ISSUES?

Send an email to asktom@sharesmagazine.co.uk with the words ‘Retirement question’ in the subject line. We’ll do our best to respond in a future edition of Shares.

Please note, we only provide information and we do not provide financial advice. If you’re unsure please consult a suitably qualified financial adviser. We cannot comment on individual                 investment portfolios.

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