The pros and cons of cashing in a final salary pension

Almost two years from the introduction of pension freedoms, one clear trend has emerged, in the shape of a spike in demand to cash in final salary or defined benefit (DB) pension schemes.

Momentum is increasing at a time when transfer values are at record levels. Various providers have commented on a surge in demand, including pension consultancy Hymans Robertson. The firm notes that over the past six months the number of employees requesting quotations from administrators to transfer out has increased by 170 per cent when compared to pre-April 2015 levels.

Below we explain why financial salary pension transfers are on the rise, and look at the pros and cons of transferring.

How final salary pensions work

Final salary or defined benefit pensions are looked upon with envy by the non-baby boomer generation. The schemes were rolled out by employers during the 60s, 70s and 80s, offering workers a guaranteed income for life when they retire.

The amount has historically been based on a percentage of a worker’s final salary multiplied by the number of years they have been in the scheme, though more recently schemes have been modified to base payouts on a less generous ‘career average’ salary.

As well as typically being inflation-proofed, most schemes also tend to offer a continuing spousal income, usually 50 per cent, upon the death of the pension holder.

Nowadays, except in the public sector, the vast majority of those entering the UK workforce will find themselves paying into defined contribution pensions, whose fortunes are linked to underlying investment performance. Final salary schemes became increasingly unaffordable for employers, for a number of reasons including increasing levels of life expectancy.

The transfer window is open

As things stand today, there has never been a better time to consider cashing in a final salary pension. This is down to the fact that transfer values (the transfer offers on the table from employers) are at record highs. Some schemes are offering transfer values of 40 times the annual pension, so £800,000 today for an inflation-linked pension of £20,000 a year for life. Offers on the negotiating table are much more generous compared to previous years. As a rule of thumb, prior to the pension freedoms transfer values were typically around 20 times.

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Transfer values have risen so dramatically because yields from bonds – in which final salary and defined benefit pensions are mainly invested – have fallen to record lows. Low bond yields increase the cost to pension schemes as they need larger funds to produce the same income, which is why they are keen to reduce their liabilities and get pension savers with financial salary pensions off their books.

Why the benefits are not worth giving up

For many, the benefits are essential and not worth giving up, particularly for those who do not have other resources to rely on in retirement.

Those who transfer out will ‘incur investment risk for the rest of their lives’, points out Gary Smith, a chartered financial planner at Tilney Financial Planning. Therefore those considering cashing in need to think long and hard about whether they want to gain control over their pension pot and make investment decisions themselves, which will involve deciding how much pension cash to take out of a pension each year.

This, however, is far from easy and requires investment knowledge, as well as time and dedication. Therefore, most people who take the cash will have to go down the route of in effect ‘hiring’ a financial adviser, financial planner or wealth manager to make investment decisions on their behalf.

But Smith adds that most of those who view themselves as ‘cautious’ should probably steer clear, no matter how attractive the carrot being dangled in front of them, because of the inherent risks attached to stock-market investments, which are needed to deliver a sustainable income through retirement.

He makes the further point that the impact of inflation is often undervalued or overlooked completely.

‘Most defined benefit pensions include annual inflationary increases (these can differ vastly between schemes), which effectively retain the ‘real’ purchasing power of the income during retirement. Indeed, a starting pension of £13,475, at age 60, would increase to £24,408 by age 90 assuming an annual inflation rate of 2 per cent,’ says Smith.

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The Financial Conduct Authority has also taken a cautionary stance on final salary pensions. It previously warned that ‘in most cases you are likely to be worse off if you transfer out of a defined benefit scheme, even if your employer gives you an incentive to leave’.

Charles Calkin, a financial planner at James Hambro & Partners, says he agrees with the financial regulator’s position. ‘All ceding schemes insist you show that you have received appropriate independent advice before being allowed to transfer out of a pension with anything more than a cash equivalent transfer value of £30,000. Given the strong views of the regulator and concerns about professional indemnity, advisers are often hesitant to engage in this work,’ he adds.

Reasons to cash in a final salary pension

For those who have other assets to help generate retirement income, transferring can work as a means of passing the pension on to younger generations of the family.

In the case of defined benefit schemes, the benefits stop when your spouse dies. If you both die early – it is simply a case of tough luck. Moreover, if you are widowed or divorced the pension will end on your death, with no benefits paid to children or grandchildren.

By transferring out, your pension pot can be passed on to whomever you wish. ‘For those who are seeking to leave a legacy to their family, then by transferring out and into a personal pension plan they can leave the whole fund to them on their death,’ adds Smith.

In addition, thanks to new rules brought in a couple of years ago, transferring may prove worthwhile for inheritance tax planning purposes. Heirs now just pay income tax at their marginal rate when the money is withdrawn – and that only applies when the person from whom they are inheriting the money was over the age of 75. For pensions inherited on deaths before the age of 75 there is no tax to pay.

Therefore, for those in the position of being able to draw on other assets, the pension pot should be the last thing to touch. ‘Many of our clients now draw on their non-tax-wrapped savings first and Isas second, leaving their pension savings till later in life, to help reduce any inheritance tax liabilities on their estate,’ says Calkin.

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