Jeff Salway: Final salary schemes gamble for many

The shake-up allowed defined contribution scheme members to access entire pension pots from 55 without heavy tax penalties. Picture: Thinkstock
The shake-up allowed defined contribution scheme members to access entire pension pots from 55 without heavy tax penalties. Picture: Thinkstock
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TAKING advantage of new pension freedoms may seem like a good idea, but there are important factors to consider, says Jeff Salway

A SURGE in requests for transfers out of final salary schemes has heightened concerns over the number of people sacrificing generous guarantees so they can take advantage of new pension freedoms.

You have to think about the returns and risk associated with the alternative

Demand for transfers out of final salary – or defined benefit (DB) – schemes has rocketed since pension access rules changed in April.

The shake-up allowed members of defined contribution (DC) schemes to access their entire pension pot from the age of 55 without incurring heavy tax penalties. Up to 25 per cent can be taken tax-free and the remainder is now taxed at the saver’s marginal rate, rather than the previous 55 per cent.

The new “freedoms” don’t apply to DB schemes, but transfer rules have been relaxed to enable members to switch into DC arrangements and take advantage of the changes.

Enquiries about transfers from DB to DC schemes have more than doubled since April, according to new research from Selectapension. The increase has been even greater than employers, pension firms and advisers had expected.

Gregor Munro, financial planner at Johnston Carmichael Wealth, said: “We’ve seen a surge in the number of clients considering a switch from their DB pension into a DC scheme. They are, however, very different structures and, in many ways, it’s like comparing apples to oranges.”

The pension income provided by DC schemes is variable, being based on factors such as the amount paid in, charges and investment performance. DB schemes, in contrast, pay a guaranteed pension income based on earnings and length of service.

Anyone with a DB pension pot worth more than £30,000 must take regulated financial advice, but relatively few advisers are qualified to oversee pension transfers.

Many of those that are qualified have been turning “insistent” clients away, in fear of being seen to endorse transfers that are unsuitable (and therefore leaving themselves vulnerable to claims further down the line).

Two-thirds of complaints made to the Financial Ombudsman Service (FOS) about pension transfers were upheld between 2011 and 2014, noted Iain Wishart, owner of Edinburgh-based Wishart Wealth Management.

“This figure is even more surprising given the fact the Financial Conduct Authority heavily regulates this area of advice,” he said. “Whether this figure is down to genuinely poor advice, poorly recorded advice or perhaps some ‘flipping of coins’ at the FOS is unknown. Advisers would do well to adopt a sceptical outlook from the outset.”

The problem is that while DB scheme members are often attracted to the flexibility offered in the new environment, many fail to appreciate the value of their guaranteed arrangements.

The number of people cashing in their DB pensions was on the rise even before the reforms, as employers sought to reduce their pension costs by offering members cash incentives to transfer out.

So how do you know if the transfer value being offered is worth sacrificing the guaranteed benefits?

“One important factor which can often suggest whether a transfer will deliver ‘good value’ is the multiple of the pension you are choosing to forgo compared to the transfer value,” said Munro.

“Clearly every scheme is slightly different but we are currently seeing major fluctuations of multiples on offer, varying between 12 and 33 times the pension at retirement, a huge variation.”

If the offer doesn’t appear to be good value it usually means the critical yield – the return that the alternative arrangement must achieve year-on-year just to match the DB pension – will be very high.

The current cash equivalent of the transfer value, providing a detailed breakdown of the calculations, is also important. This is where interest rate expectations might come into play.

“The current cash value can fluctuate significantly and right now, due to low gilt yields, there are increasing inquiries about a potential window of opportunity to act before interest rates increase and currently high transfer values are likely to fall.”

There are plenty more factors to consider, including objectives, other assets and income, and the individual’s health and family history.

There are some scenarios in which transferring out might be the best course of action. They include cases where health issues may curtail the individual’s retirement, or where there’s no-one to inherit the pension at death.

“Each case on its own merits – that has to be the message. Staying put could be a financial error for some,” said Wishart.

But most DB members are advised to stay put and benefit from a guaranteed income in retirement that they’d be unlikely to get from any other arrangement.

“Being able to turn an income stream into a large capital sum can often appear attractive at first glance, but you have to think about the returns and the risk associated with the alternative arrangement,” said Munro.