Pension dilemma: £659,000 today, or £22,000 a year for life?

For many years, the consensus among experts was that no one in their right mind would transfer out of a defined benefit (DB) pension scheme; but the world moves on and things have changed, not least the amount of money an employer may offer you to leave their workplace scheme.

While 18 months ago a DB scheme might have offered you around 20 times your annual expected pension as a cash sum to transfer elsewhere, that figure today is more likely to be 30 times your expected annual pension. This is a result of low gilt yields, rising life expectancy and rising infl ation expectations, which all make the pension benefits promised by the scheme more expensive to deliver.

For example, you would probably now be offered a transfer value of at least £659,000 in exchange for an annual DB pension of £22,000, compared with £440,000 on a 20x basis in 2015. Some schemes are even offering 40 or more times the value of expected pensions. The attractions of the DB guarantee begin to fall away once you reach a level where the cash sum, even before investment returns, is in itself sufficiently large to pay out an identical pension until you are very elderly.

Gilt yields tailwind

A key factor is gilt yields, which are used by actuaries to calculate what the transfer will be worth in real terms in the future. The lower the gilt yield, the bigger the transfer sum needs to be. Gilt yields dropped sharply last spring, with the 15-year rate hitting a low of 0.98 per cent in September. They have since risen to 1.59 per cent, but this is still much lower than at any time in the past 30 years.

A handy way to gauge current trends in transfer values is the Xafinity Index (see chart, right), which tracks the transfer value provided by a DB scheme to a member aged 64 and entitled to a pension of £10,000 each year from age 65, increasing in line with inflation. In February, this figure was £237,000, which was just £6,700 below its all-time high recorded in October 2016.

‘Transfer values for the over-50s have generally been rising for the past three decades as bond yields have progressively fallen,’ says James Baxter, managing partner at Tideway Investment Partners. ‘The general trend is still upwards, although there are some signs this may have plateaued, if not started to reverse. We have seen a number of large schemes, including British Airways, RBS and Scotia Gas Network (ex British Gas), make quite large downward adjustments as volumes of transfers increase typically 10-15 per cent. We think this is a function of the obligation on trustees not to pay out at rates that makes the funding worse for those who remain.’

- The pros and cons of cashing in a final salary pension

Baxter points out that higher transfer values are balanced by lower expected returns on investments, so while someone transferring now will receive a better cash off er than someone who transferred in, say, 2012, their investments are likely to pay lower returns. ‘This is borne out in our customer base, with those who transferred in 2012 having 30 per cent plus returns over the last fi ve years,’ he says. See box on page 51 for more on returns.

Additional Sipp appeal

Beyond transfer values, there are various other attractions to a self-invested personal pension (Sipp).

Flexibility: Sipps offer greater flexibility to take the fund earlier and front-loaded, compared with the flat payments of a DB pension. People in their 50s, for instance, may want access to cash while they can enjoy it to the full, perhaps to fund a lifetime ambition, set up a business or put children on the housing ladder. That could make particular sense if both partners in a couple have a generous final salary pension.

Inheritance tax: When a DB scheme member dies, the scheme typically pays a monthly income to a surviving spouse worth around half to two-thirds and sometimes a small amount to children still in education. In a Sipp, if you die before age 75 the benefits can be paid to any beneficiary you name, completely tax-free. On death after age 75, the benefits can be drawn down or paid as a lump sum taxed at the beneficiary’s marginal rate. So attractive is this from an IHT perspective that some advisers suggest you should deplete all your other assets before drawing income from a Sipp.

Defined benefit risks

You may want to consider transferring if you think your pension scheme is in difficulty. Some DB schemes are five or even 10 times the size of the sponsoring company, and as they come up to maturity they face real difficulty meeting the cash flows required to pay member benefits as people retire. The PLSA (Pensions and Lifetime Savings Association) task force, which as the DB trade body is close to these schemes, estimates that 50 per cent might not pay full member benefits.

Unfortunately DB pensions are not as guaranteed as generally assumed. If your scheme has a large deficit, the trustees have a duty to weigh up the merits of forcing the scheme to continue paying benefits versus preserving the company and jobs for the workforce, and there are many cases where trustees have negotiated with the current employees to reduce pension benefits accrued.

If a sponsor goes bankrupt, the scheme falls into the Pension Protection Fund (PPF) safety net, but for anyone who has not yet reached scheme retirement age, the PPF pays only 90 per cent of what their pension is worth at the time. The annual compensation you receive is further capped at a certain level. This is £38,505 (£34,655 when 90 per cent cap is applied) for someone at 65, but varies by age.

Looking ahead, the government and pensions industry are considering weakening the annual indexation of pensions to help schemes stay afloat. In many cases this would mean a ‘statutory override’ allowing schemes to link annual benefit rises to CPI instead of RPI, saving schemes around 0.7 per cent per year. This would make a surprising difference, compounding up to around £72,000 over retirement for our case study member, with benefits of £22,000 per year. If your scheme links benefits to RPI and has a large deficit (particularly relative to the employer’s size), this is worth bearing in mind.

Whether the transfer offered is good value will also depend on how your scheme revalues benefits built up before 1997. Legally, pre-1997 benefits do not have to be indexed at all, but some generous schemes allow for annual revaluations of 3 or even 5 per cent, adding a considerable amount to a transfer value.

If you do decide to transfer, you should probably get on with it as the whole process can easily take six months. Furthermore, schemes that are in deficit are obliged to reduce the transfers they offer, to be fair to all members, and more may start doing that.

Transfer downsides

Against this shifting landscape, there are some drawbacks to transferring to a Sipp.

Investment hassle: In addition to the absence of guarantees, you will face a lifetime of monitoring your investments or paying a professional to do it for you. You could do worse, however, than following Warren Buffett’s guidance for his wife’s finances in the event of his death – he recommends putting the money in a cheap index tracker and leaving it there. Currently, however, that could well mean buying in at the top of the market!

Lifetime Allowance (LTA): The LTA is the amount you can draw down from your pension at your marginal rate of tax, currently £1 million if you have not protected it at a higher amount. If you take any more, you will be penalised with an additional tax charge. Before age 75, the tax charge is effectively 55 per cent. At age 75 the fund is again tested against the LTA, with any excess retained in the drawdown fund charged at 25 per cent. For this reason, many people have called the LTA a tax on investment performance.

What kind of income could you expect?

If you decide to transfer, and your transfer is £30,000 or over, the government insists you employ an independent financial adviser who will produce projections based on various investment returns and income levels to give you a better understanding of how long your money would last.

Pension adviser Tideway offers a useful interactive calculator, allowing you to key in your own details.

Baxter suggests real annual returns of 1 to 2 per cent should be assumed for these projections, based on a gross return of 4 to 5 per cent a year from a balanced portfolio minus inflation at 2 per cent, and platform fees that depend on whether you manage your Sipp investments yourself (typically 0.3-0.5 per cent) or take professional help (1.5 per cent plus for advice and portfolio administration).

The table below shows that even at conservative levels, an investor could boost the income taken to £26,000 each year and not exhaust the fund for 35 years.

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