Should you stick with your final-salary pension scheme?

published 10 March 2017

Most financial advisers assume that members of final-salary pension schemes are better off sticking with them. After all, these defined-benefit (DB) plans offer certainty about the pension you'll receive for the rest of your life. Defined-contribution (DC) pension funds leave you vulnerable to unpredictable markets.

Despite the advantages of DB schemes, Old Mutual Wealth has just revealed that the number of its advisers considering whether to suggest clients transfer their money from a DB to a DC scheme increased by 65% last year. That followed a 91% rise in the previous year. Why? First, the transfer values offered by DB pension schemes to people taking their money elsewhere have soared (see below). Second, advisers and savers have realised that DC schemes can have some advantages over DB plans.

DC plans offer more freedom to pass on pension to heirs (see below). They also give you direct control over your savings. By contrast, what you have in a DB scheme is a promise that will only be met if the scheme or its sponsoring employer is able to stand behind it. If the scheme is underfunded, the employer fails and the pensions protection fund (PPF) has to take on paying the benefits, members may get less than they expected. Most people will get 90% of their benefits, but those with large pensions could lose more. The PPF also pays lower inflation-linked increases to pensions than many DB schemes.

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However, even if transfer values today look generous, there is no certainty anyone would be better off taking them. That would depend on getting good investment returns you could easily end up worse off. DB transfers are therefore still not appropriate for most savers.

Request a transfer value if you want to consider your options, but take independent financial advice before going ahead (this is a requirement on transfers worth more than £30,000). It may be difficult and expensive to find an adviser to work on a DB transfer, because they tend to be complicated and carry a high regulatory risk. Many providers of cheap self-invested personal pensions will also not accept transfers from DB schemes.

How transfer values are calculated

The transfer value that you'll be offered by a defined-benefit (DB) pension scheme depends on a number of factors. However, one of the most important considerations is the prevailing level of interest rates and gilt yields, since these determine the long-term cost of providing benefits.

UK interest rates are currently at an all-time low, having been reduced to just 0.25% in the wake of the Brexit referendum last summer. Gilt yields have bounced slightly upwards in recent months but remain very low by historical standards. The result is that transfer values are currently unusually high, having risen sharply over the past 12 months. Where once someone leaving a DB pension scheme might have expected to be offered a transfer value of between 20 and 25 times their notional annual pension, this could now have increased to 30 to 35 times. So if you have earned the right to a pension of £15,000 a year, your transfer value today could be worth between £450,000 and £525,000.

That said, those figures are towards the upper end of what schemes might pay and doesn't mean that all will offer a transfer value of 35 times your pension. The more generous the scheme is in areas such as dependants' benefits and the rate at which pensions increase in line with inflation in retirement, the higher the transfer value. What's more, schemes may offer higher ("enhanced") transfer values to encourage members to transfer out, so that the employer can reduce its liabilities (always take advice in this situation and never transfer just because you're being offered an incentive). Conversely, your transfer value may be adjusted downwards if your scheme is underfunded.

Untransferable benefits

Once you've started claiming your DB pension, you're no longer entitled to transfer your benefits to another pensions arrangement whether you started claiming last week or years ago. Starting to take your final-salary benefits is just like using a defined-contribution pension pot to buy an annuity that guarantees a lifetime income; under current legislation, neither transaction is reversible. It's also important to note that no transfers out of unfunded public-sector pension schemes where pensions are paid out of the public-sector budget, rather than from a dedicated pot of pension savings are allowed. Such schemes include the Teachers' Pension Scheme and the NHS scheme, but not the Local Government Superannuation Scheme.

How a move will affect your heirs

The rules on inheriting pensions represent the strongest argument for transferring out of a defined-benefit (DB) scheme for many people. The pensions freedom rules introduced in April 2015 brought in valuable new rights for personal pensions. Broadly, any unused money in your pension fund can be passed on to heirs. If you die before age 75, the money will be tax-free, while for deaths after that age, your heirs will pay income tax on the inheritance at their marginal rate of income tax.

This is a big attraction of an income-drawdown plan, which allows you to continue investing your pension fund even after you've started taking benefits from it. But drawdown is not available to DB pension savers, for whom the rules on passing on pensions are much less flexible. Once you start drawing your DB pension, your heirs would typically only be entitled to a dependant's pension on your death, usually of no more than 50% of what you were receiving.

However, some care is needed. If you transfer a pension and then die soon afterwards say within two years HM Revenue & Customs has powers to investigate the transaction. If it decides that the transfer was made to avoid an inheritance tax bill, it may charge inheritance tax on the money that was passed on. This has happened in cases where someone with a terminal illness has transferred out of a DB scheme and died shortly after. Your adviser should discuss this issue with you.

David Prosser is a regular MoneyWeek columnist, writing on small business and entrepreneurship, as well as pensions and other forms of tax-efficient savings and investments. David has been a financial journalist for almost 30 years, specialising initially in personal finance, and then in broader business coverage. He has worked for national newspaper groups including The Financial Times, The Guardian and Observer, Express Newspapers and, most recently, The Independent, where he served for more than three years as business editor.