Time to switch out of a defined benefit pension?

The UK pension funds liquidity crisis has, quite understandably, shaken confidence in defined benefit (DB) pensions.

People with these final salary-linked schemes got very worried when the news broke of fund managers having to sell assets in a hurry and the Bank of England riding to the rescue.

The truth is that there is no need to panic: experts say these schemes are secure, at least for the foreseeable future. Accountancy firm PwC, which monitors the universe of more than 5,000 DB schemes, says they are now overall better funded than ever before.

There’s further reassurance if your employer is expanding or even if they are just treading water — as long as the company remains in business, it has an obligation to honour its pensions promises. And even if it goes bust, the Pension Protection Fund offers a valuable safety net.

That said, there is also no harm in thinking soberly about your options. For the rise in interest rates that helped to trigger the turmoil has also highlighted a key shift in retirement income choices.

After years in which DB pensions offered the best guaranteed pension income, those who now cash in their final-salary chips can benefit from a 52 per cent rise over the past nine months in rates on annuities — contracts offering a guaranteed income stream.

Depending on your age, scheme and health, an annuity might now offer a higher income than your DB pension. Plus, you might be able to buy better inflation proofing than your DB scheme too.

But higher income isn’t the only consideration. Switching to an annuity may be worthwhile for more people than before — but it’s still not for everybody.

For those who have one, a DB scheme is the starting point for a secure retirement and for many it will form the bulk of retirement income. So before making any changes, understanding the facts, risks, and alternatives, is essential.

Check your pension scheme’s funding levels by finding the fund’s statement, which counts up assets and liabilities, on the scheme’s website. If it’s 100 per cent funded (or higher), great. Below 80 per cent and I’d be asking questions.

It’s also worth requesting a cash equivalent transfer value (CETV). This is the amount your pension is classed as being worth if you wanted to leave the scheme.

You are legally entitled to have one CETV a year free. Asking for one comes with no obligation to leave — and you can request an extra one for a few hundred pounds.

Overall, in a high-inflation, high-interest rate environment, transfer values have fallen from their peak in November 2021.

LCP, the actuarial firm, says that in the last quarter of 2021, the average transfer value quotation was a little over £400,000, whereas in the first half of this year it was around £300,000 — a 25 per cent drop.

CETV quotes are scheme- and person-specific so you won’t really know “how much” until you make the request.

Square Mile Asset Management, a transfer specialist, says they have previously seen heady scheme-specific multiples of up to 70 times. On average it says the falls this year have been around 20-40 per cent, meaning you could roughly expect to get a multiple of 25-35 your projected final salary income.

Next, compare the projected DB guaranteed income with the income you could generate with your CETV.

Suppose you have a final salary pension projected to pay you £12,000 a year from the age of 65. A modest valuation of 25 times projected income would give a CETV of about £300,000.

You could draw that £12,000 (4 per cent) today directly from your investments through income drawdown, in a self-invested personal pension. But, while you could be fairly confident the money would last, there would be no guarantees.

The alternative route to a guaranteed income is an annuity, where rates have shot up more dramatically than transfer values have fallen. Nick Flynn, retirement income director at Canada Life says: “It’s been a record-breaking year for annuity rates, with incomes at a level we haven’t seen for over a decade.”

A benchmark level annuity of £100,000 at age 65 now pays a guaranteed income of £6,873 a year, compared with £4,521 at the start of 2022. That might seem attractive even if your transfer value is modest.

Inflation-linked annuity rates have also seen a significant improvement over the past nine months, with rates improving by 77 per cent. A benchmark £100,000 annuity linked to RPI pays a starting income of £3,896.

Inflation annuities are often dismissed as poor value — it takes 16-17 years to match the payments from the level [non-inflation-linked] annuity.

And, if you’re after double-digit inflation protection over the very long term, watch out for caps on the uplifts to inflation-linked annuities.

It’s also worth checking the inflation protection within your DB scheme — you might be even more disappointed.

The statutory minimum requirement is to provide inflation protection on post-1997 service only. This is up to a cap which was initially 5 per cent, but was cut to 2.5 per cent on later service.

While some adopt the bare minimum, Pension Protection Fund data show the large majority offer inflation capping at 5 per cent and most schemes link this to the RPI [the retail price index, which is now running above CPI].

Fewer than 10 per cent of DB schemes provide uncapped inflation cover. Unlike annuity companies, a very well-funded DB scheme might make discretionary top-ups to help pensioners when inflation exceeds 5 per cent — though this doesn’t happen very often.

So on pure investment grounds, some will find reason to leave a DB scheme and others won’t. But there are some additional personal drivers for exiting a DB pension that make transferring out more desirable. If one of these applies to you, I would act quickly.

Ranking high is the need for more flexibility. Despite the guarantees of a DB pension, it is not as flexible as a DC pension. You can’t vary the income you take, nor draw out larger lump sums (apart from the tax-free lump sum offered by some final salary schemes).

Second, a DB pension cannot be inherited. If you die prematurely, a portion of your DB pension may continue for your spouse, but the rest is lost, and nothing passes to your children. By contrast, unused funds in a DC scheme can be passed to beneficiaries on death, free of inheritance tax.

Being single or in poor health can also be good reasons to leave. A single person wouldn’t benefit from the spouse’s pension or need DB’s death benefits. If you have a health condition or lifestyle that limits life expectancy you could benefit from enhanced annuity rates.

A big hurdle in transferring is finding an adviser. If your transfer value is over £30,000, you are legally required to obtain regulated advice. However, most DB transfer advisers dropped out following scandals such as the British Steel Worker pensions affair, where employees lost their life savings on bad DB transfer advice, and the introduction of new fee rules.

There remain a handful of specialist firms. Even so, good luck finding one that agrees moving is sensible. The financial regulator ensures the bar for recommending a switch is incredibly high.

So don’t even approach an adviser unless you’re well prepared and at least 90 per cent sure transferring out is right for you.

Plus, don’t ignore the expense of transferring and the ongoing charges that result. In effect, your DB pension is guaranteed net of charges, but commission on an annuity could take 3 per cent of your transfer value, while managing a Sipp in drawdown entails paying regular fees, which will eat into your returns.

On balance, unless you’re vastly wealthy or in poor health, I’d sit tight in your DB scheme — it might not be gold-plated but in uncertain times it’s still the best armour you have. Even if annuity rates are the best in 14 years.

Moira O’Neill is a freelance money and investment writer. Twitter @MoiraONeill, Instagram @MoiraOnMoney

 

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