Should you trade in your final salary pension?

Published by Rachel Lacey on 30 July 2015.
Last updated on 31 July 2015

Pension pig

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."

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