Soaring incentives threaten final salary benefits

Holders of final salary schemes shouldnt let high transfer values and access to pension freedoms go to their heads. Photograph: Getty/iStockphoto
Holders of final salary schemes shouldnt let high transfer values and access to pension freedoms go to their heads. Photograph: Getty/iStockphoto
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The risk of people in defined benefit pensions giving up valuable benefits has grown after an “extraordinary” increase since the EU referendum in the cash offers being made to tempt members out of the schemes.

Employers offering defined benefit (DB, or final salary) pension schemes have stepped up their efforts to move members out of them over the past three months as the cost of funding pension promises continues to rise.

Just 13 per cent of DB schemes are open to new members these days, according to The Pensions Regulator, but there are still some 15 million people in DB schemes in both the public and private sector.

Cashing in a DB scheme and giving up the guarantees you’re entitled to is rarely the best move, experts say, and the regulator’s position is that most members should stay put.

But more are likely to transfer out as cash offers reach new highs in the wake of June’s referendum. Transfer values rose by 7 per cent in August alone, according to the latest transfer value index from actuarial firm Xafinity, published on Thursday.

“An increase of 7 per cent in just one month is extraordinary, and illustrates the eye-watering sums potentially now on offer to members of defined benefit pension schemes,” said Paul Darlow of Xafinity.

Hazel Brown, pensions director at Edinburgh-based Carbon Financial Partners, said some schemes had increased transfer values by up to 50 per cent since Brexit.

The increase reflects the impact of the referendum outcome on gilt yields, which DB schemes use when working out the value of the benefits they’ll have to pay out in future.

The fall in gilt yields since June means the cost to schemes of funding future promises has gone up.

“At the beginning of August, yields were around 1.11 per cent and much lower than in August 2015, when they were around 2.2 per cent, and in 2008, when they were over 5 per cent,” said Brown.

Most pension savers are now in defined contribution (DC) schemes, where the eventual pension depends on factors including contributions and investment performance. In contrast, the income from DB schemes is based on earnings and length of service and is guaranteed.

Demand for transfers away from DB pensions leapt after the April 2015 introduction of the so-called pension freedoms. Members of DB pensions can only take advantage of the freedoms by switching to a DC scheme, although they must take advice if they’re transferring a pot of £30,000 or more.

“The main risks of members transferring are the same as they always have been – returns from investments being less than expected so the fund becomes exhausted quicker,” said Brown.

“More usually though, the danger is people not sticking to the planned withdrawal rate, taking too much in the early years and not reviewing the fund on a regular basis to gauge the impact.”

The concern now is that members who would be better off remaining in their scheme will be lured out by the attractive offers being made, not only by employers but also by fraudsters.

“I think there is a real risk that pension scammers will seek to exploit this by convincing unwary members to move their pension into bogus investments,” said Darlow.

However, there are certain people for whom a transfer out might be the best course of action, including those with no one to inherit their pension when they die, or who have health issues that could make their retirement a short one.

One compromise is to take a partial transfer value, where the pension trustee allows it.

“This is beneficial for both parties as it allows the scheme to reduce long-term liabilities and it allows the member to enjoy the flexibility of the new pension freedoms with some of their fund, whilst still maintaining a guaranteed minimum level of income in future,” said Brown.

But transferring out is rarely the best long-term option, and there are various factors to think about, such as tax implications, your other assets and income and your financial objectives.

“Anyone considering taking a transfer should look at a projection of their specific situation and fully ‘stress test’ it using different growth rates and ‘what if’ scenarios,” said Brown.

One of the challenges members face is the three-month period for which the transfer value quote they’ve been given is valid. This doesn’t allow for proper planning, said Brown.

She said that with demand increasing some scheme administrators are taking several weeks to respond to requests for full details of the member’s pension benefits.

Large transfer values can be a result of long service rather than high salaries, Brown added.

“We had one client with a transfer value of over £700,000 but who was around £50,000 in debt, had no cash reserve and had no other investments. It was a real danger of ‘jam today’.”