A defined benefit pension is one where the benefit is defined at the date of retirement.
You know how much you’ll receive from your pension each year (and it will typically rise each year in line with inflation). This income is guaranteed for the rest of your life, as well as often having a spouse’s pension linked to yours guaranteed for the rest of their life.
A defined benefit pension is based on the number of years you’ve been in the scheme and your salary. There are two main types of defined benefit pensions:
A cash equivalent transfer value or CETV is basically the sum of money your defined benefit pension scheme will offer you if you transfer out of the pension plan.
If you accept the CETV your employer’s pension fund is offering, you forfeit the right to any future retirement income from the pension scheme. This is known as final salary pension transfer.
In exchange, you receive a pot of cash invested in a money purchase scheme to use to provide your own retirement income. This is similar to those who have been saving into a defined contribution or money purchase pension scheme all along.
The cash equivalent transfer values final salary pension schemes are offering their members in exchange for those members transferring out of the pension have increased notably in recent years. This is partly down to schemes being keen to move the risk of members’ pension entitlements off their books in an era of rising longevity and depressed investment returns.
Some schemes have been offering members enhanced CETVs to encourage them to leave the final salary pension scheme.
As such, you might have recently received a tempting cash equivalent transfer value from your pension scheme, but just what does that high CETV mean for you and your retirement? What are the advantages and disadvantages of transferring your final salary pension, and why are pension transfer values so high in the first place?
Defined benefit pension plans have long been considered the gold standard for pensions because they pay an income from retirement to your death, usually index-linked to keep up with inflation. Many defined benefit pension plans also provide a reduced pension for a spouse after the pensioner’s death (known as a widow’s pension).
Those promises have proved very expensive, and many defined benefit pension schemes have closed to new members or even gone bust due to issues of affordability.
Today, defined benefit pensions are only offered by the largest private companies or the public sector.
Many final salary pension plans have found their investments haven’t performed as expected due to a series of economic shocks from the 1980s onwards, the largest and most recent of which was the financial crisis of 2008/09.
Leading on from the financial crisis has been a decade of record-low interest rates and poor yields on government bonds, both of which have impacted schemes’ returns.
UK defined benefit pension funds invest heavily in government bonds (also known as gilts), but demand for gilts soared among nervous investors wanting a safe return, pushing up the price but depressing yields.
In light of these affordability issues and rising longevity, employers are increasingly keen to shift the long-term liability of final salary pension payments off their balance sheets. Today’s high CETVs are partly a carrot to entice members to transfer out of their pension scheme.
With current pension transfer values so high, it may seem very tempting to transfer your defined benefit pension. But if your pension fund has recently sent you a sizeable cash equivalent transfer offer through the post, is it worth cashing in your final salary pension for the lump sum?
Whether or not you should transfer your final salary pension will depend on your personal circumstances, although for the majority of people it won’t be the right course of action. This is because a defined benefit pension provides a guaranteed income for the rest of your life, security that’s hard to match with a transferred defined contribution pension.
There are both positives and negatives to final salary pension transfers; some of these are outlined below.
Although your defined benefit pension offers you a guaranteed income for life, there could be benefits to transferring out of your pension plan in limited circumstances. These include:
One of the biggest risks of a final salary pension transfer is that you’re giving up a secure income for life. The move is permanent: you can’t transfer back in.
Other drawbacks include:
If your defined benefit pension is worth more than £30,000 it is a regulatory requirement to take financial advice.
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