The benefits of final salary pension schemes
Defined benefit and final salary pensions are often seen as 'golden' pension deals.
This is because final salary pensions give you a guaranteed income when you come to retire, which often rises with inflation each year and pays attractive death benefits (such as a pension to your surviving spouse).
This kind of deal is really expensive to replicate if you have a defined contribution pension, which sees you save into a 'pot' which is invested and then you decide how to take an income from it.
To get a guaranteed, inflation-linked income with a defined contribution pension, you would need to buy an annuity.
Using the Money Advice Service's annuity calculator (moneyadviceservice.org.uk), a pension pot worth £500,000 would only buy you an annual income of just over £15,000 a year.
That why usually best to leave your money there rather than transferring to your new employer's defined contribution pension.
Why transfer your final salary pension?
As part of the April 2015 pension freedoms, you may be permitted to transfer from a private defined benefit scheme to a defined contribution pension.
This has transformed the retirement plans of thousands of people.
If you have a defined contribution pension, you can now withdraw as little or as much as you like; managing your savings more flexibly through income drawdown– rather than having to buy an annuity.
Another change is the removal of the 55% tax on your remaining pension pot after you die. Under the new rules, if you die under the age of 75, your funds can be inherited tax free. If you die aged over 75, it can be passed on as a lump sum subject to income tax at your heirs' personal rate.
These changes make the prospect of quitting a generous final salary pension, and transferring the cash you could get to a defined contribution scheme, far more attractive.
How much will I get if I transfer my final salary pension?
If you do decide to transfer your final salary pension, the amount you get to invest is known as the 'cash equivalent transfer value', which is calculated by your final salary scheme.
You must then invest this 'amount' in either a pension scheme with another employer or a personal, self-invested or stakeholder pension.
The cash-equivalent transfer value is the amount of money your pension scheme would need today to make sure it could cover the cost of the benefits you were guaranteed to receive in the future, were you not to cash them in.
Think of it as a big pot set aside to make sure you were paid an income that rose every year, and paid out to your spouse after you died.
To ensure that it could meet this promise to you, the scheme would have invested this big pot of money in the markets.
So, for the scheme to calculate how much your pension is worth today, it needs to make assumptions about how the money would have grown.
Gilts and your final salary pension
Many schemes invest in UK government bonds, or ‘gilts’. These are essentially loans to the British government in exchange for a fixed rate of interest, with the loan repaid at a future date.
Gilts are seen as low risk, as the UK government is unlikely to go bust and therefore not repay its debts, which is useful for pension schemes because they pay incomes for decades and need secure investments.
However, returns on gilts have fallen in recent years. So, if the scheme assumes that growth on its investment is going to be lower, it would need a larger lump sum today to cover the cost of your future pension benefits – meaning a larger cash equivalent transfer value for you.
If it had a different investment strategy – say it invested more in shares – and it predicted the money would enjoy better returns, it may pay you a smaller lump sum.
It’s tough to know what makes a good or a bad deal, as different companies use different assumptions for the returns on their investments.
Final salary pension transfers: FAQ
We answer your key questions about final salary pension transfers.
Who can transfer their workplace final salary pension?
If you hold a private sector final salary pension, you have the right to request a transfer, as do members of 'funded' public sector schemes.
A funded scheme is one that sets aside a pot to pay out pension incomes to employees.
Some public sector schemes, such as those for teachers or NHS workers, aren’t linked to specific pension funds (they’re paid out of general taxation) so members of these can’t transfer out.
If you’ve already started drawing on your pension, you won’t be allowed to cash out, and if you do decide to make the switch, you’ll be leaving the scheme for good.
When might you transfer your workplace final salary pension?
In some circumstances, perhaps if you aren’t reliant on the final salary income only, a transfer could make sense.
A transfer would give you the chance to pass on some of the cash as an inheritance. That can’t usually be done with a final salary scheme.
Cashing in might appeal if you only receive a trivial amount each month and a lump sum would prove more useful.
For example, a £60 per month could translate into a cash-in value of around £25,000, based on 35 times the annual income. The figure with differ depending on your pension scheme
When shouldn’t you transfer your workplace final salary pension?
You might decide to transfer yourself or be persuaded by an adviser to do so. Stories about pension schemes being in deficit – ie the fund owes more money to members than it will be able to pay out – might prompt you to transfer your cash.
The reality is that people are protected by the Pension Protection Fund (PPF), a government-run fund to protect people in DB pensions that go bust.
If you’re already retired you’ll get 100% of your pension if you were past normal retirement age.
If you are yet to retire, you are likely to get 90% of your pension once you reach normal retirement age. Pay-outs are capped.
Do I have to take financial advice to transfer my pension?
Anyone making a transfer worth more than £30,000 must seek financial advice. There are many advisers with specialist qualifications to assist on transfers, but there are also cases of poor advice on pension transfers identified by the FCA.
Some advisers will charge on a ‘no-switch, no-fee’ basis, which will mean a large fee if you cash out, and nothing if you don’t. This could cloud their decision on what is best for you.
A reputable adviser should:
- Consider what you need (or want) from your pension, based on your financial circumstances and goals.
- Consider how well your existing pension will provide for this.
- Consider which alternative arrangements are suitable for you – and if the benefits are enough to outweigh the cost of switching.
- Explain the potential risks and benefits of switching or staying put.
- Explain clearly what the advice will cost you and, if you switch, the fees you’ll need to pay.
What to do with the money from your workplace final salary pension?
If you do decide to cash out, you’ll need to plan what you’ll do with the proceeds. A reputable adviser won’t sign off a transfer without providing alternative recommendations.
The most common arrangement is income drawdown, allowing you to leave your pension pot invested in the market.
By staying invested, you may benefit from capital growth and income from your investments – but there’s a chance you’ll either run out of money.
Alternatively, you could buy an annuity, but it is unlikely you will be better off cashing in a final-salary scheme to do this. Annuity rates are very low for the same reasons transfer values are high.
You may also think about cashing in your pension to invest in another way entirely, such as buy-to-let property.
But be careful – you can only access 25% of your pension tax-free; you need to pay income tax on the rest.
How long could a final salary pension transfer take?
Our step-by-step guide takes you through the stages of transferring your pension.
The first stage
You request a 'statement of entitlement' from your pension scheme
After one month
Your pension scheme should notify you that you need to take professional financial advice
After three months
Your pension scheme confirms the 'transfer value' of your pensions and will send paperwork with a deadline to take financial advice
After six months
This is your deadline to confirm that you want to transfer your pension and provide proof that you've taken financial advice
After nine months
This is the deadline for your pension scheme trustee to complete the transfer.
Problems with pension transfer advice
There has been a fair amount of adverse press coverage around ill-advised transfers from the British Steel Pension Scheme.
Employees were told that their scheme was closing and were given a choice between switching to a new scheme or cashing out.
Unscrupulous advisers have then told people that they should swap their ‘at risk’ pension for money in the bank. Others were advised to opt for highly unsuitable pension alternatives, with expensive and unclear charges.
Read our guide to how to find a financial adviser to find a reputable one, and think very carefully before you transfer.