Giving up your defined-benefit pension isn’t so crazy

Those of us who don’t have defined-benefit (DB) pensions have long been envious of those who do. Imagine having a guaranteed income for life on retirement. A sum of money that will turn up every month forever, regardless of what you do or don’t do, and regardless of how long you live. A sum that will rise with inflation – so that your “real” retirement income never falls. And, of course, a sum that comes with guarantees for your dependants as well. If you die, they’ll keep getting the money. Knowing that you have all of this in the bag must provide a wonderful sense of security.

Yet increasingly large numbers of people are willing to give it up. They aren’t crazy. They are realising that while there are risks in transferring out (swapping your DB pension for a lump sum to manage yourself), there are excellent reasons for doing so too.

The first is that very low interest rates have made transfer values bizarrely high: ask how much you would get for giving up your DB rights, and you are likely to be told it is around 35 times the value of your annual pension (so £10,000 a year could be swapped for £350,000). That’s real money. The second is that there is a growing possibility that your DB pension won’t pay out as you expect it to. The firm sponsoring the pension fund could end up unable to meet its obligations (particularly if it is unable to retain good staff or invest in the future, thanks to the endless demands from pension fund trustees trying to cover their deficit).

Also, the rules might change. Take the calculation of the lifetime allowance (LTA). The LTA is £1m: have a pension valued at more than that and you pay a 55% tax on the excess. Today a DB pension is valued for LTA purposes at 20 times its projected payout ratio – so you can have an expected pension income of £50,000 before you hit the LTA. But if, as the transfer values on offer suggest, their real value is more like 30-40 times the projected annual payout, then there has to be (and should be!) a risk that DB valuation methods for tax purposes will change – and not in your favour.

Other possibilities include the watering down of inflation indexation for DB pensions, as discussed in the government’s recent Green Paper on the system’s sustainability (conclusion: it is in a pretty ropey state – see page 23). Finally, note that most private DB pensions have limits on inflation linkage. While your scheme will raise your payout by RPI or something similar every year, the small print often caps that at 5% a year. If inflation rises above that again (something policymakers are desperate for), most DB pension holders’ income will fall in real terms anyway. So if you have a DB pension, call and ask for a transfer value. Transferring out comes with risk (you must take proper advice). But don’t think for a second you aren’t also taking substantial risks by not transferring out.

  • Colin Peters

    Great piece and as one of those very lucky people I have recently been told I have a transfer value of 35 times on my DB scheme. However, I have been told by more than one pension expert that no IFA in their right mind would sanction a transfer ( thier insurance will not cover such a risky piece of advice ) and therefore no one (HarGreaves Lansdown for example) will not accept a transfer if your advisor does not support the transfer in writing, They all do privately it seems. So this freedom we have been given is just not as it seems!

  • Gary Bell

    Given that HMRC value a DB pension for LTA purposes at 20 times its projected payout ratio then for those who are approaching the LTA threshold… it’s good that they do use a factor of 20 and not say 35… you’re able to get more value from your pension without exceeding the threshold.