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.
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.