Defined Benefit pensions: DB or not DB?
Colin Dyer | April 17, 2017
“DB, or not DB?” – That is the question. And for most people the answer is going to be “DB!”
A Defined Benefit (DB) pension – sometimes known as Final Salary – gives you a guaranteed income for life, and provides great security in your retirement. This is a huge advantage because your employer takes on all the investment risk and is obliged to meet the “pension promise” regardless of how the underlying investments have performed.
Such schemes are increasingly few and far between as most schemes are now closed to new entrants and the future accrual of benefits. So those who are in one are often seen as very lucky. However you can choose to transfer out and leave these advantages behind…
Transferring means giving up your DB pension in return for a cash equivalent transfer value which can then be invested. These lump sums can make people feel like overnight millionaires, and tempting as that may be, you need to understand that as well as the money you’re also taking on responsibility to invest it wisely for the future – because suddenly the risk’s all on your shoulders.
Transferring out is a one-off decision but the investment risks are ongoing once it is made. It’s a challenging and complex matter and the stakes are high – there are no second chances once you decide to leave the security of your scheme.
Why would you even consider this?
At its simplest level, transferring becomes a trade-off: DB offers security through a stable, increasing and predicable income for life. Whereas Defined Contribution (DC) pensions offer more flexibility around how you can take benefits, which may allow you to control when you pay income tax, and since legislation changes in April 2015, give you greater freedom to pass on the money in your pension plan to your family or other beneficiaries.
Another factor is that transfer values for DB schemes have risen over the last 12 months, to what would historically be a fairly high level. But just because you’re offered a tempting figure doesn’t mean it’s the right thing to do – it’s a huge decision and the impact should not be underestimated.
What’s driving the high DB transfer values?
There are several forces at work here, but the bulk of the increases in recent years have been driven by:
- Falling gilt yields
- Lower expected investment returns
- Improved life expectancy
Gilts are bonds issued by the UK government and are a type of low-risk investment. The economic and political turmoil of recent times have increased demand for gilts, and therefore driven down the yield they give to investors. This has had a big impact on transfer values because DB schemes rely on gilts to match the pensions they have promised.
Improved life expectancy also drives up the cost of providing DB pensions as schemes have to pay out for longer than they would’ve originally anticipated. This, along with falling gilt yields which lead to the expectation of lower investment returns in the future, all combine to increase the value placed on DB pensions today.
What to think about?
Like most complex scenarios, DB transfers should not be thought about in isolation.
You need to think about more than just your pensions fund here, and view things in the wider context of your goals, all your investments, and family situation – taking into account financial considerations such as tax planning and managing inheritance.
With that said, although your personal circumstances will have a big impact on the suitability of transferring, here are my first four questions for people considering a pension transfer:
1. Do you need a guaranteed income?
Many of our clients like to have a high degree of peace of mind regarding their retirement income. So particularly when it comes to essential expenditure, such as month to month living costs, DC flexibility won’t necessarily outweigh the value and certainty of the DB income promise.
On the other hand, for some people a DB income for life may simply mean surplus income and paying the associated income tax. In this you may want to consider transferring as the ability to take income and tax free cash from a SIPP at the levels you need, when you need it, may give you a more tax efficient income and a larger legacy for your loved ones.
Working out the level of income you need is absolutely key, as it’s essential to have a high degree of confidence that your money will last throughout what could be a long retirement.
If you leave the security of DB you have to be prepared for the possibility that you could run out of money, which is particularly concerning in later retirement when your income needs might rise, perhaps due to care expenses.
2. Do you have excess money you want to pass on to your children?
DB schemes usually pay a widow/widowers pension or dependant’s pension on your death. However, depending on when you die, DC pensions can give you the ability to pass more of your accumulated pension wealth to future generations who may not be eligible under DB scheme rules. As long as it leaves you with peace of mind regarding your own income needs, it could be a way to help with their financial future.
3. Do you benefit from all aspects of a DB pension?
If the answer’s yes, you should stay where you are.
However, the ‘one size fits all’ nature of DB means people who are single, or have reduced life expectancy, may want to consider switching to a DC solution as it may give better death benefits and higher income – depending on investment returns, of course.
4. Are you willing to take on investment responsibility?
Leaving the protection of a DB scheme means that you become responsible for your own pension investment. It is very important to understand that investments carry risk and can go down as well as up, meaning that you could get back less than what you originally invested.
Deciding whether you can accept that responsibility will depend on your attitude to risk and your capacity for loss. Knowing what you can afford to lose is fairly complex, but a financial planner can help work out what feels right for you.
At a high level, those are the questions that I would ask first. But there’s a lot more to consider if you want to avoid surprises down the road, including:
- Ensuring you understand all the benefits you are giving up in your DB pension scheme
- Understanding how the Lifetime Allowance may affect you
- Checking your entitlement to state pension
- Dealing with a potential inheritance you may receive or may leave to your loved ones
These are fairly technical areas so I won’t go into more detail here, but if you are considering a DB transfer, your financial planner will take all this into account when doing a thorough review of your personal circumstances.
So what should you do?
As outlined in this article, there are many, significant benefits to DB schemes. If some of the potential benefits of DC are of interest to you, speak to a qualified financial planner. They will help you really think through the relative risks and benefits on each side of the argument.
At 1825 we have Pension Transfer Specialists who would be happy to help. One caveat up front though – if we don’t think transferring is the right thing for you to do, we won’t do it for you. The impact of the wrong choice here could be hugely detrimental to your quality of life in retirement so it’s incredibly important that you only do it if it’s the best option.
Laws and tax rules may change in the future. The information here is based on our understanding in March 2017. Personal circumstances also have an impact on tax treatment. Investments can go down as well as up and you may get back less than you pay in. The information in this blog or any response to comments should not be regarded as financial advice.