What Do High Final Salary Transfer Values Mean For Your Pension?

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24-07-2020

What is a Defined Benefit Pension?

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:

  • Final salary schemes
    Where your pension at retirement is linked to the salary you were earning just before you retired
  • Career average schemes
    Where your pension is linked to an average of your salary across your time spent in the defined benefit pension scheme.

What is a Cash Equivalent Transfer Value?

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?

Why Final Salary Pension Transfer Values Are So High

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.

Losses and Liabilities

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.

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Should I Transfer My Final Salary Pension?

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?

Advantages and Disadvantages of Transferring Your Pension

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.

Benefits of Final Salary Pension Transfers

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:

  • If your former employer goes bust or the pension fund runs into trouble, you won’t be affected as you’ll already have transferred out.
  • Having a defined contribution pension providing your retirement income means you can leave some of your pension to your children or other beneficiaries. With most final salary schemes, the pension dies with you / your spouse.
  • The new pension freedoms offer huge flexibility for arranging a pension income, such as the ability to increase and decrease income in any given year to suit your tax situation.
  • If you’re in poor health and / or a smoker, you may have a lower life expectancy, something defined benefit schemes don’t tend to adjust for. That means you might draw on your pension plan for fewer years than a healthier, longer-lived colleague in the same scheme, so they could receive more than you. If you transfer out and are in poor health, you might be able to make use of an enhanced annuity to boost your retirement earnings or make arrangements to leave your pension to beneficiaries after you’re gone.

Disadvantages of Final Salary Pension Transfers

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:

  • You’ll have to take on the investment risk and make investment decisions for your pension fund yourself.
  • The value of pension investments can fall as well as rise in a defined contribution scheme, meaning you could get back less than you invested.
  • If your investments don’t perform as well and / or you overspend, you might run out of money. This is where pensions advice is essential for planning the retirement you deserve.
  • One of the most common ways those with money purchase schemes secure a retirement income is by purchasing an annuity. However, annuity rates at the moment are poor unless you have a health condition that warrants an enhanced annuity.

If your defined benefit pension is worth more than £30,000 it is a regulatory requirement to take financial advice.

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