The ins and outs of defined benefit pensions
Published: 30 September 2016
Defined benefit (DB) pensions returned to the headlines earlier this year after commercial crises at BHS and Tata Steel shone fresh light on the pressure that these schemes are under.
DB pension schemes provide what has often been described as the ‘gold standard’ for pensions – a guaranteed income at retirement. But a report on the BHS saga by the Work and Pensions Select Committee warned that their future was “the greatest challenge facing longstanding British businesses”. It added that “defined benefit pension liabilities accumulated in a different age can appear burdensome and unaffordable” at a time when people are living longer and interest rates are at record lows.
One proposal being considered by the UK government is a change in rules to allow DB schemes to reduce the benefits their members have already built up (accrued). This would involve circumventing Section 67 of the Pensions Act 1995, which prevents accrued benefits being reduced without the consent of scheme members.
So far, the government has said this is only being considered for the case of Tata Steel (to make the business more attractive to buyers). But commentators believe it is likely to come under pressure to consider a general overhaul of the legislation as other sponsoring employers look for ways to ease the DB burden.
As at the end of August, more than eight in 10 of the DB schemes under the Pension Protection Fund (PPF) had liabilities greater than their assets, according to the PPF 7800 index for that month. The outcome of the EU referendum has, if anything, exacerbated the problem by pushing down the gilt yields that are used by DB schemes when calculating the reserves they need to meet their future liabilities.
Thinking the unthinkable?
The idea of transferring out of a DB scheme was once considered almost unthinkable. Yet one upshot of the latest turmoil could be increased interest in doing just that. The pension reforms of April 2015 had an effect that may be similar, with DB members having to transfer to defined contribution (DC) schemes if they want to take advantage of the greater flexibility.
Added to both of these, reducing gilt yields since the EU referendum are pushing up some of the cash equivalent transfer values on offer to DB scheme members to record highs.
DB schemes each have their own rules about how and when you take your benefits. It’s one of the trade-offs for the guaranteed income they provide. So, especially if you are concerned about the longer-term funding of your DB scheme and its ability to pay out your benefits by the time you come to retire, the opportunity to exercise more control over your pension pot can seem attractive. Particularly if you are comfortable with managing your own investments in retirement.
There are, however, significant pitfalls. The most obvious is the risk inherent in sacrificing the guaranteed income that DB pensions provide in retirement (usually a percentage of your final salary at retirement) and instead exposing yourself to investment risk in a DC scheme. Aiming to build up a pot of money you can use to provide an income at retirement, with no certainty of the outcome attached.
That’s why anyone who wants to transfer a DB pension with a transfer value of more than £30,000 must take financial advice. The complexity of pension transfers means it’s often worth taking advice even if your pot is worth less than £30,000. The advice process includes a pension transfer value analysis. This is a regulatory requirement and tells you the estimated investment return your new DC pension pot would need to produce to make sure you’re no worse off from the switch.
Some issues to consider
There are several things to think about if you’re considering a transfer from a DB scheme, and that would be covered in the advice process.
To begin with, make sure you are clear on the benefits attached to your scheme. As well as your own guaranteed pension, other benefits can include life cover or a guaranteed pension for your spouse should you die. Are these important to you? And if yes, how much would it cost you to replace them?
You’ll pay investment and other charges in a DC pension. Make sure you understand what these are and the impact they might have on investment returns in your new DC pot over time. If you’re transferring to a private DC pension you should get a personal illustration that gives you this information. The types of fee you pay can make a difference here too.
Investment charges are usually set as a percentage of the value of your pot, especially if you are investing in collective funds. If you hold your new DC pension on an investment platform (like Alliance Trust Savings) you’ll also pay a fee to the platform. That might be a percentage of the value of your pot too. Or it could be a flat fee. Alliance Trust Savings charges a monthly flat fee on its pension account.
Percentage fees generally work out better if your pot is smaller, but if you have a larger pot – for example because you’re now consolidating a number of different pensions into one place to make things easier to keep track of and manage - flat fees may work out best for you. Flat fees don’t grow with the value of your investments. Percentage fees do.
The flat fees difference
As you’ll have to make decisions about where to invest your money in a DC pension, before committing to a transfer it’s also important to be clear on your overall financial objectives, your likely income needs in later life and your attitude to (and capacity for) risk. If you’re risk averse and uncomfortable with taking investment risk in retirement, for example, the greater flexibility and choice offered when it comes to taking income from DC pensions will be of limited, if any, value for you.
Look before you leap
It still holds true that transferring out of a DB pension is only likely to be a good idea for a small minority of people, even with the question marks hanging over the future of DB schemes.
If you’re thinking of a transfer it’s essential to look before you leap. Taking professional advice is generally a good idea, and you must if your DB transfer value is £30,000 or more.
If it turns out you are one of the very few that could potentially benefit from making a move, consolidating a DB pension into a DC pot with other pension savings you have built up – making it easier to keep track of things and potentially saving on charges too - is one of several ways to make it work for you.
Important informationThese articles are designed to help investors make their own investment decisions. They do not constitute a personal recommendation to invest. If you have any doubts as to their suitability you should seek expert advice. Please be aware that the value of investments can fall as well as rise so you could get back less than you invest.
Your existing pension may have valuable benefits which you might lose when you transfer.
Laws and tax rules may change in the future without notice. The information here is our understanding in August 2016.This information takes no account of your personal circumstances which may have an impact on tax treatment.
Past performance is not a guide to future performance.