Defining the benefits of DB transfers: members and families

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The introduction of the ‘Pension Freedoms’ in 2015 gave members of Money Purchase schemes (such as a SIPP or a SSAS), the option to withdraw as much of their pension fund as they like, subject to income tax (apart from their tax-free cash sum).

Another change was the increased flexibility in distributing death benefits from such schemes. It is therefore, no surprise that we have seen a significant upsurge in transfer requests from defined benefit occupational pension schemes, which typically do not afford such flexibility.

However, given the secured retirement income being sacrificed on transfer, the Financial Conduct Authority imposes that such transfers in excess of £30,000, cannot proceed without the member having first obtained advice from a regulated financial adviser. The following case studies illustrate the factors that members and advisers alike should take into account when deciding on the suitability of the transfer.

John

John is aged 55, single and recovering after a short illness. He has limited savings and is not in receipt of any state benefits. Having taken redundancy in his late 40s, John is a deferred member of the Local Government Pension Scheme (LGPS). They provide a tax-free lump sum and secured pension to members reaching the scheme’s normal retirement Age of 60, as well as a reduced spouse’s pension on the member’s prior death. As there is a history of early mortality in his family, John is not hopeful of living a long and healthy life and his attempts in taking early retirement from the scheme has, to date, been unsuccessful. John would therefore prefer to transfer his entitlement and make use of the Pension Freedoms while he can. Since his current scheme’s actuaries have calculated his transfer value at £175,000, John must obtain financial advice. John’s adviser compares the benefits provided by the LGPS with those available under a money purchase pension arrangement to determine which option better meets John’s circumstances.

The adviser determines the critical yield for replacing the LGPS benefits as 5.6%, which is unlikely to be achieved given John’s attitude to risk and capacity for loss. However, John is now entitled to take unlimited benefits from the money purchase pension arrangement from age 55. Once his 25% tax-free lump sum has been paid, he will also be able to draw any available amount as (taxable) pension income. On death before age 75, any individual nominated by John can receive a tax-free drawdown pension from the residual funds for the rest of their life, or John could nominate a charity to receive a tax-free lump sum. On balance, given John’s specific circumstances and needs, the advice given is to transfer.

For the member: John is able to draw a tax-free lump sum immediately. Though still modest, a higher flexi-access drawdown income would have been available under the LGPS for taking benefits five years earlier and he is able to use the funds to provide a better and happier lifestyle for himself. As such, he feels the benefits outweigh the drawbacks of managing the funds himself and risking depletion of his savings during his lifetime.

For the family: John’s younger siblings can potentially be provided with a lump sum and/or pension income following his prior death, whereas the LGPS would only provide a pension to a member’s surviving spouse.

Sarah

Sarah is 53, married, and in good health. She is a deferred member of a defined benefit occupational pension scheme, with 20 years’ service. At her normal retirement age of 60 within the Scheme, she will receive an index-linked scheme pension of 1/80th of her final salary for every year of service. She will also receive a tax-free lump sum equivalent to three years’ pension. In the event of her prior death, the first five years’ pension payments are guaranteed and her husband will receive 50% of her pension entitlement for the remainder of his life. She has been provided with a transfer value of £250,000 and, understandably tempted by this, obtains financial advice as to whether a transfer to a money purchase arrangement is the right option for her.

Sarah’s adviser points out that it is extremely unlikely she will be able to either replicate or improve the retirement and death benefits offered by her current scheme by investing the transfer value elsewhere; in particular almost an 15% annualised rate of growth would be required. In addition, transferring to, for example, a self-invested personal pension would put the investment responsibilities and risk squarely on Sarah’s shoulders, whereas her current scheme is funded by her employer. The adviser concludes that the element of security offered within the defined benefit arrangement makes it advisable to stay within the scheme.

For the member: there are several benefits to remaining within her current scheme such as: the reduced paperwork and administration when compared with a self-invested personal pension, the additional security given by the fact it is funded by her employer and the security of a known benefit structure. Sarah is risk averse, plus the costs and charges of running the scheme are also paid for by her employer. If her circumstances change, Sarah can always request another transfer value 12 months prior to age 60 and taking her benefits from the scheme.

For the family: Sarah’s husband will receive a pension for life should she predecease him, whereas a money purchase arrangement may be entirely depleted by such a time, depending on the amount of benefits withdrawn and the underlying investment performance. The Scheme also offers the security of a five-year guaranteed payment period, should she die shortly after retiring.