Pension savers have lots of reasons for considering a defined benefit (DB) pension transfer but often find rules laid down by government financial watchdogs stonewall plans to make the switch with a negative DB transfer report.
The Financial Conduct Authority oversees how pensions work for consumers and takes the initial view that transferring a DB pension is a poor investment decision because retirement savers give up valuable financial benefits when making the switch.
While savers and their advisers agree DB pensions have valuable and attractive rights, some of the conditions for gaining the financial benefits are too rigid.
If you are thinking about transferring your DB pension, here we explain what the rules are and how they affect your pension.
What is a defined benefit pension?
For many years, workers employed by private firms saved into a company pension that provided a guaranteed retirement income based on how long they had worked for the business and how much they earned.
These rules defined the scheme’s benefits, which is where the name derives from.
All DB pensions offer the same four basic rights, although how much they pay varies from scheme to scheme.
These rights are:
- A guarantee no one runs out of money in retirement as the payments will last the saver’s lifetime
- The surviving spouse receives a payment until they die, generally half of the amount the worker was paid
- Spending power is protected by cost-of-living increases
- A guarantee that the level of payment is maintained regardless of how the stock market or other fund investments perform
DC pensions – the alternative
Over the years pensions and what retirement savers want from them have changed to a more flexible model, called a defined contribution scheme (DC).
DC pensions rarely offer guarantees, Some older schemes may have a guaranteed annuity rate, but this is uncommon.
Payments are based on the value of the pension fund and can rise and fall as the trading value of the underlying assets move.
Many modern company pensions are DC schemes as the cost of providing a DB scheme is seen as too expensive by employers.
Why savers want to transfer out of a DB pension
Pension savers have lots of reasons for considering a DB transfer, but they typically boil down to five factors:
DB pensions have a set retirement age and taking an early pension is not usually as generous.. The scheme pension age is often 60 years old, with some retirement ages rising to the state pension age for the worker’s age group, i.e. 66 or older.
Most DC schemes now let savers take some or all their retirement savings from the age of 55.
Tax-free cash bonus
Income from DB and DC pensions are subject of the same tax rules and allow savers to take a 25% tax-free lump sum.
However, with a DB scheme, the tax-free amount can be less than 25% of the lump sum because of the way the figure is calculated.
Calming employer solvency worries
Recently, several large employers have gone bust leaving the Pension Protection Fund to pick up the pieces.
Although the PPF guarantees to keep paying pensioners at the same rate as the employer, new retirees will see the money they get reduced. Under these circumstances, many workers opt for a DB transfer to protect the value of their pensions
Bad health can cost savers money
DB pensions pool risk and those with the shortest retirements subsidise those that live longer. Transferring out of a DB pension for someone in poor health can safeguard the level of their pension
Weighing up the spouse pension
DC pension rules allow relatives to benefit from unspentpension funds. For some couples, especially those who are not married, transferring out of a DB scheme can make sense as the pension can be left in full to the surviving partner, regardless of maritial status.
When the surviving spouse dies, the pension fund dies with them, while a DC fund can be passed on through the generations
What the rules say about a DB pension transfer
The Financial Conduct Authority (FCA) is the government watchdog that regulates the pensions advice industry.
The FCA is quite clear about the expectations a retirement saver should have about a DB pension transfer:
- The best financial interest of most retirement savers is to remain in a DB pension
- If someone wants to consider a DB pension transfer, the FCA expects firms to give advice to savers that is ‘suitable and appropriate to their needs and situation’
Two other points that affect the right to transfer are savers cannot transfer out if they are with 12 months of the scheme’s retirement age, or when the scheme is under the wing of the Pension Protection Fund.
Why DB pension transfers are always negative
When a financial adviser works on a DB pension transfer analysis, they are looking at risk.
But some advisers argue the comparison formula is rigged by the FCA so the DB analysis will always give a negative return.
The FCA says to make the DB analysis fair, all advisers need to work to the same framework so savers can easily compare the benefits and drawbacks of different schemes.
Critical yield was the traditional figure to consider. Critical yield is the annual investment return needed from the new pension in order to replicate the benefits offered by the DB scheme.
The FCA has updated what to include in the analysis. This still includes a section to assess the critical yield, but stretches the analysis to cover a deeper calculation on the expected rates of return on each asset or fund in which the pension is invested.
These rates are often tiny or negative, giving rise to the negative DB transfer report.
Advisers explain pension savers will never have risk-free investment of their funds, and as savers meet the costs of a DB transfer which reduce the fund value, the DB transfer analysis is always likely show a recommendation not to transfer.
They add that because gilt yields are so low or negative more money from the fund is needed to buy a comparable income and if a saver is looking for a guaranteed or escalating retirement income, they should probably not transfer out of a DB scheme.
The result is a DB transfer analysis will almost always give a recommendation not to switch schemes.
DB pension transfer FAQ
The Appropriate Pension Transfer Analysis is the updated review for a DB pension transfer required by the FCA. The APTA analysis recommends if a DB transfer is suitable for a retirement saver.
The TVC is the Transfer Value Comparator, which shows the cost of buying the same benefits of the DB scheme from a new DC pension scheme.
An insistent client is someone who goes against the recommendation of their adviser when making a DB pension transfer. For insistent clients, advisers adopt a three-step process: Give clear advice about making a DB pension transfer to the client – Explain the risks of making the transfer – Make sure the client knows proceeding with a DB transfer is against the APTA recommendations
If there is a financial loss due to the transfer, this process is meant to protect the adviser from a claim for compensation if the switch means they lose money.
No. If you decide you were better off in the DB scheme, you cannot change your mind about the transfer.
No. Public sector schemes do not have a fund, so have no transfer value as benefits are paid out of the contributions of today’s workers and employers.
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