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

  • MM68

    Just discussed this round my desk at work. One colleague who went through a divorce a few years ago paid to have his now ex-wife’s pension independently valued because his final salary transfer value (as a multiple of the expected annual pay out) was more than twice that of his wife. He saved himself a lot out of the settlement.

    Great article

  • Jonathan Parsons

    Very useful article, I shall be investigating this further.

  • A Frith

    I don’t know. With £300k you could invest in a good group of ITs and produce a fairly safe income of around £6000 per annum and hope to beat inflation.
    It would depend on how secure your occupational pension fund is (a BHS or a Civil Service scheme) and how much income from other sources you had, and how much you wanted to leave your next of kin.
    Ordinarily I would say someone in their 50s with no other source of income should not cash up a db pension.

    • haggardt

      But these are not ordinary times. Extraorinarily low returns on bonds are the result of unprecedented government intervention. To guarantee a future stream of cashflows (i.e pension) requires a huge capital sum. It is the equivalent of reducing gravity in the physical world.

      I believe all this is set to reverse – higher inflation / interest rates – lower bond / db pension valuation / equity / property prices. Cash will then be very valuable again.

    • Horiboyable .

      I would be cashing up very quickly. Most pension funds when they were setup were modelled on a 6 to 8% interest rate and for over a decade now that has been unachievable. This will have forced pension funds to take riskier positions in their search for yield so when the economy turns down hard the loses will start mounting up. Also some countries make it compulsory for pension funds to buy sovereign bonds and folks for some reason think these can not blow up. They have selective memory because the whole of Europe defaulted on their sovereign bonds back in 1932. Traditionally, when countries debt to gdp goes over 100% they eventually default. This is the process we are in now, France, Italy, UK, Greece, Portugal, Spain and Belgium have way too much debt, they all have shrinking populations. Germany has tried to counter this issue by letting in anyone that turns up at their border; good luck with that Merkel, I am sure the female citizens are thanking you for this cultural enrichment. Illiterate refugees are not going to replace retiring engineers at BMW.

      Pension funds are already started to blow up all around the world, this includes many municipalities. Here in the UK the government does not even declare all of its pension liabilities because they know they will never be able to honour them. Here in the UK pension funds are short about 600 billion to a trillion. Lots of folks are going to be disappointed that is for sure.

      • Yes it’s hard to see how the current pension arrangements can be sustainable.

        Government bonds (in the UK anyway) can never default, though. That doesn’t mean that the rampant inflation resulting from governments meeting their obligations won’t make the value of cash a lot lower than we might like. But then we’ll all be stuffed, if we hadn’t invested in hard assets like gold.

  • richard

    To get a sense of the value of index linking, my DB pension is not inflation-linked and the buyout proposal available to me is 24x. (I am a similar age to the individual in the article). The long-end of the gilt market is pricing in inflation of approximately 3.5% (index linkers at -1.58% real vs fixed at 1.9) and the intermediate 10-15 yr part of the forward inflation curve is even touching 4%. This to me suggests a scarcity problem with inflation linked assets rather than a general expectation that inflation will be that high but anyone with an index linked DB pension thinking of cashing out should consider what the market is implying.

  • shaun

    hi i want to transfer a DB final salary pension but i need an IFA to give the ‘advice’. advice we I dont have to take the administrators just need a letter signed to say that the advice has been given.. now thing is i want to manage my own SIPP but all of the IFA’s i have contacted firstly want to charge for the ‘advice’ .. thats fine but secondly want to manage the ruddy thing and go on about ethics and all that baloney.. its a if they are scared that folks will go running back to them if they lose all their money punting it on AIM.. thats my choice though … whole point is I want the funds transferred to for examle ‘you invest’ platform and manag it myself…
    can anyone help!

    many thanks