Should you trade in your final salary pension?
However as part of the new freedoms, savers with defined benefit schemes - which include final salary – can transfer their money into defined contribution schemes in order to take advantage of the reforms.
But is it a good idea? To protect members of defined benefit schemes – who will automatically get a guaranteed, inflation-linked income for life when they retire – they will have to prove that they have had regulated financial advice before they can cash their scheme in, if their pot has a transfer value of £30,000 or more.
Whether you will need to take advice to transfer out or not, we spoke to Wealth at Work, for its top 10 considerations every individual needs to make before they trade in such a valuable benefit.
1. Do you really need the cash?
Withdrawing cash has serious tax implications, only the first 25% will be paid tax-free and the remainder will be taxed at your marginal rate. If the money is deposited in a savings account it may then become subject to savings tax.
According to Wealth at Work it may make sense for someone who does not need the dependant benefits of final salary schemes, is seriously ill or needs a lump sum to pay off debts. But even in these instances it still may make more sense to leave your money where it is.
2. Is the paperwork correct?
Check the information on your paperwork is correct and up to date before making any decision. It is not uncommon for statements to quote pension entitlements based on the date you left the scheme. However, if this was many years ago, inflationary increases may mean your actual entitlement is significantly higher.
3. Compare transfer value against annual income
Consider the cash equivalent transfer value against your current pension entitlement (see above), to find out how many years' income you would need to receive before you reach the full transfer value.
For example, a retiree with a transfer value of £27,384 or annual guaranteed income of £1,355.58 would end up 'better off' with the income option in a little over 20 years. This is a simplistic calculation – it does not factor in any returns on a lump sum invested or inflationary increases to income, nor does it take tax into account. However, it does provide a good starting point to the decision making process in terms of whether it would offer good value to you.
4. Don't forget defined benefit perks
Final salary and other defined benefit schemes will often include useful benefits such as 50% of a spouse's pension (whether you die before or after you retire). Others offer increases of as much as 5% if you defer taking benefits and provide inflation protection once payments start. Some also offer death benefits if you die with five years of retiring.
Other schemes may offer 'scheme protected tax-free cash', which is greater than the statutory 25%. Depending on your own personal circumstances, this may make your final salary benefits look more attractive.
5. Compare the value against an annuity
Compare the annuity income you would be able to buy with the transfer value of your final salary scheme with the income you would receive if you leave your money where it is. Wealth at Work has calculated that a transfer value of £27,000 – paid instead of an income worth £1500 a year – could cost as much as £60,000 if all the final salary perks were to be included such as starting at age 60, with index-linking and protection for a spouse.
6. Check the guaranteed minimum pension (GMP) value
This is the minimum value that an occupational pension scheme has to provide to members who were contracted out of the State Earnings Related Pension Scheme (SERPS) between 6 April 1978 and 5 April 1997. The amount is 'broadly equivalent' to that which would have been paid had they not contracted out.
This figure is not usually calculated until retirement and as such is rarely up to date on transfer value statements. Increases to the GMP can be as much as 8.5% a year depending on the scheme and how long ago you left it. This rate applied to some schemes where members left before April 1988 so some 27 years ago. The compounded effect of this rate over 27 years would increase this element of your pension nine times according to Wealth at Work making transferring out look substantially less attractive.
7. Changing transfer values
Bear in mind that transfer values can change from year to year due to a variety of economic and demographic factors including investment performance and mortality rates. As a result, make sure your transfer value is up to date before making your decision, rather than relying on statements from previous years.
8. What is the real value of your pension?
Your transfer value is literally just the cash lump sum that your scheme is able to give you in lieu of income and it does not reflect the 'true' value of your scheme when factors such as inflation-linked income and benefits for spouses are taken into consideration.
Calculating this true value is incredibly complicated but financial advisers will have access to transfer value analysis systems to help them value final salary schemes, so to get a better picture of your final salary pension's real value you may want to consult an expert.
9. Will your scheme pay out?
Your scheme is only as strong as the company behind it, so if your employer fails your pension is at risk. As such, it is no surprise some individuals are worried about whether or not their scheme is secure. This may mean cashing in is worth considering if your employer is in a precarious position. However, don't rush into making a decision and consider all your options.
The Pension Protection Fund exists to safeguard members' incomes when their scheme collapses but it may not pay out as much as you expect. It currently pays 90% of your pension value and there is a maximum benefit cap of just under £33,000 a year.
10. Do you fully understand your options?
People with pensions valued at less than £30,000 don't have to take advice but that doesn't necessarily mean you shouldn't. Pension transfer documents are notoriously complicated and full of jargon – it may also be that they are not up to date. If you don't have an accurate idea of your pension's true value – including additional perks that would be lost on transfer – you won't be making a decision with full knowledge of the facts.
Jonathan Watts-Lay, director Wealth at Work, which provides financial education, guidance and advice in the workplace, says: "In some cases if you are seriously ill, or want to start a business and cash is more important to you than your long-term income planning, it may be worth cashing in your final salary scheme. However, in the majority of cases an individual would be better off to leave it as it is and both the Financial Conduct Authority and The Pensions Regulator agree."
The cash equivalent transfer values (CETV) is an assessment of the total accumulated cash value of a pension you will be able to take out of your existing pension and move into a new one should you change employers or decide you want to move to a more flexible scheme with greater benefits and lower administration costs. The transfer value will depend on the trustees of the pension fund assessing your contributions and investment growth to determine the transfer value, which may have to be certified by the scheme’s actuary.
State Earnings Related Pension
SERPS was the name of the government’s additional pension scheme that lasted until April 2002 and it is now called the State Second Pension (SP2). Anyone earning more than over £75 a week and had not “contracted out” would have been building up an additional pension under SERPs. If you started a personal pension plan, you “contracted out” of SERPs and the government paid part of your National Insurance contributions into the plan once a year in the form of a rebate. However, as SERPs was directly related to earnings, the amount people will get when they retire will vary.
Final salary pension
A defined benefit pension scheme is one where the payout is based on contributions made and the length of service of the employee. A typical scheme would offer to pay one-60th (0.0168%) of final salary (the one you’re earning when you finally retire) for each year of contributions to the scheme (even though these years were probably paid at a lower salary). Someone retiring on a final salary of £30,000 who had been a member of the scheme for 25 years would receive a pension of 42% of their final salary (£12,300 a year before tax). Sadly, many companies are winding up their final salary schemes or closing them altogether, meaning pension benefits accrued after a certain date (or those available to new employees) may be on a less generous money purchase basis.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).