Got a final salary pension? Now might be the time to cash it in

Pile of cash © Getty Images
Cash in while it’s worth it

Imagine you had invested in something back in 2009 and it had returned 25% every year for the past seven years – a total return of about 480%. Then imagine that the value of that investment was 100% linked to the bond market. What would you do?

The market has taught us (over and over again) that returns of 20% plus are unsustainable over the long term. And it is beginning to look like the 30-year bond bull market might end with more of a crash than a whimper: the global bond market has just had its worst month in 25 years. So I think I know what you would do: you’d sell it – as fast as you possibly could.

You may be wondering what this fabulous investment is; it is a defined benefit pension scheme. Back in 2009, a friend of mine in his mid-40s asked for a transfer value for a fund expected to pay out the equivalent of £5,000 a year when he turns 65. The answer was £63,000 – 12 times the expected annual income. That was interesting, but not enough to be worth following up. An inflation-linked income (up to a maximum of 5% a year in this case) guaranteed forever is an unusually valuable thing.

He asked again this year. This time the answer was nearly £300,000 – 40 times the expected annual income (which is now more like £7,000). Wow. We all know by now what has happened here ¬– pension funds have felt forced to value their future liabilities based on long bond yields in the UK; yields which hit record lows earlier in the year. That has translated through to individual transfer values: the more bond yields have fallen, the more transfer values have risen. So much so that even the smallest of pensions is worth a rather large fortune.

The question now is simple: at £300,000, is the transfer value so high that it is worth selling? I think it is. The first thing to say is that the price is very unlikely ever to be higher than 40 times the income; instinct tells you that’s a bubble price and, if the pace of the rise in the transfer value alone isn’t enough to scream “bubble trouble” at you, any proper analysis of the bond market has been telling you the same thing for a few years now.

Bonds are simple things: you hand over some cash; after an agreed number of years you get it back again – plus or minus a bit, depending on how close to its issue you bought it. You also get a stream of payments (coupons) along the way to compensate you for handing over the cash in the first place (the idea is that you get enough to cover inflation, plus a bit more). All fine – unless the deal doesn’t make you enough to cover inflation plus a bit more (as has often been the case over the past few years). Then there is no positive point in being in the market at all. There is only risk.

That is particularly the case now inflation expectations are rising. The US is close to full employment, wages were rising even before the election; Trump is planning to focus his administration on the one area where he actually has experience (building stuff); oil prices are rising as Opec gets a grip; and there is still a huge overhang of monetary stimulus around the world (see Japan). What could possibly go wrong?

Anyone buying bonds in this environment has been either a forced buyer (most likely a pension fund) or a speculative buyer (one who has been proven to be this bubble’s “greater fool”). There has been no value in the market for some time – and even as prices have come off a bit, there still isn’t. But a defined-benefit pension isn’t just about the value of the effective underlying assets. It’s about the certainty – and the lovely lack of responsibility that comes with it.

Knowing you’ll get paid every month forever whatever happens must be a fabulous feeling (I wouldn’t know, as I don’t have one). Can having £300,000 to invest yourself now create anything like the same certainty of £7,000 a year inflation-linked from the age 65? Assume constant pricing and no capital losses and the answer is clearly yes.

It is also yes if you take the cash, stick it in your Sipp, join the great rotation from bonds into equities, lose 30% of it in the markets and totally fail to make that 30% back over the following 20 years. Even then, you will have enough capital to provide you with £7,000 a year until you are 95 (and living to 95 is still very unusual).

The problem that anyone considering transferring out of a defined-benefit pension really needs to think about is inflation. Most defined-benefit schemes link the income they pay out to the retail prices index and will increase it every year by the lower of either that, or a set inflation cap (usually 3 to 5%). Let’s say inflation is 5% a year every year for the next 20 years. Let’s also say that you decide to play things super safe with your cash and keep it in a cash fund paying 1% a year (I don’t recommend this, but for the sake of argument, let’s say you do).

In 20 years, you’ll have £366,000. But the payment you would have got under your DB pension has gone up to £18,500. OK or not OK? Still OK. That’s a worst-case scenario – and you would still have enough in the pot to replicate 20 years of DB payments.

Things could be worse, of course. You could lose money on your investments every year, for example. But it isn’t very likely: play around with the numbers a bit and, while you can find a few periods in which equities have made a negative return, almost all show a positive return. Invest fully, reinvest dividends, diversify, keep charges as low as you possibly can and stay in the market for the long term and you very rarely lose. Add it all up and it is hard to see too much risk in taking the £300,000.

My friend is taking the money – and his chances with it. It is, he says, the last gift he expects from the great bond bull market. But it’s a good one.

• This article was first published in the Financial Times