What should final salary pension savers do?
Increases in life expectancy have made defined benefit (DB) pension schemes expensive to fund, with figures from the National Association of Pension Funds revealing that only 23% of schemes are still open.
And, with some of these set to close or alter their benefits in the future, it's important to understand your options if your scheme does change.
Some schemes, for instance the one offered by BP, close to new members. If this happens and you're an existing member, Malcolm McLean, chief executive of The Pension Advisory Service, recommends sitting tight.
"Carry on as normal," he says. "It's usually better to have the certainty of a defined benefit than to rely on investment performance in a defined contribution scheme."
Other companies take more drastic action with their DB schemes. For instance, in 2009 several firms including Barclays, Trinity Mirror and Dairy Crest, closed their schemes to existing members.
"You will usually get some form of benefit inflation, depending on the scheme details, but you won't accrue further benefits," explains Hannah Edwards, head of new clients at BRI Asset Management.
Rather than sitting tight, many schemes, whether closed or not, will look to reduce future liabilities by offering members a transfer value to leave the scheme. "Some schemes will offer other inducements, such as a cash bonus, as an incentive to move.
"Don't take this until you've taken advice from an independent financial adviser who holds J04 and J05 pension qualifications," adds Edwards.
They will run a transfer value analysis to assess what annual growth rate, known as the critical yield, you'll need to achieve to match the benefit.
"If this figure is high you'll struggle to replicate the benefits you'd have got under the DB scheme but if it's less than 6% you might be all right," says Tom McPhail, head of pensions research at Hargreaves Lansdown.
As well as assessing the critical yield you should also consider the size of the pension deficit and the financial strength of the company. "Many pensions have large deficits: these aren't an issue unless the company's struggling," adds McPhail.
Where companies do go bust, the Pension Protection Fund will pay compensation to members of the DB scheme. For anyone already retired this is 100% of the pension they would have received, while those yet to retire will receive 90% of the benefits they had accrued, subject to a cap.
This rises each year and at April 2009 was £28,742.69 for a 65-year-old. "If you've built up a pension entitlement greater than the cap and the company looks unstable, you might want to transfer out, even if the critical yield doesn't look achievable," adds McLean.
There's nothing to stop you asking for a transfer value either. For instance, each year McPhail asks his former employers to provide transfer values for his pensions so he can assess whether it's worth shifting his cash.
Where a DB scheme is closing, it's also important to weigh up its replacement if you're still an employee. Most employers will move to a defined contribution scheme, passing the risk on to you that investment returns won't be high enough.
"Push for the best deal you can in terms of employer contributions," says McPhail. "Once this is established it'll be very difficult to get your employer to increase it."
Generally a DB scheme requires funding levels of between 15% and 25% of earnings so an employer wouldn't be overly surprised if you started negotiations within that range.
|... take advice. The Pensions Advisory Service can help or speak to an IFA.|
|... weigh up the financial strength of the company to assess the likelihood of benefits being paid.|
|... negotiate a good deal on employer contributions into a replacement defined contribution pension.|
|... be won over by financial incentives to transfer. Only assess whether it's a good deal once you know what growth rate you need to replicate benefits.|
|... be afraid to ask for a higher transfer value. Schemes can be open to negotiations.|
|... forget the cap on the Pension Protection Fund, especially if you've built up a large pension entitlement.|
This article was originally published in Money Observer - Moneywise's sister publication - in March 2010
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
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.
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).
Defined contribution pension
Often referred to as a “money purchase” scheme, although offered by employers (who may pay a contribution) these pensions are more likely to be free-standing schemes that a person contributes to regardless of where they are employed. Here, the level of benefit is solely dependent on the accumulated value of the contributions and their performance as investments. Therefore, the scheme member is shouldering the risk of their pension, as the scheme will only pay a pension based on the contributions and investment performance. The final pension (minus an optional 25% that can be taken as tax-free cash) is then commonly used to purchase an annuity that would provide an income for life.
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.