Those in final-salary pension schemes breathing a sigh of relief that the economic turmoil has not affected their benefits might need to think again. Improved transfer values, the threat of employer insolvencies and an increasingly burdened Pension Protection Fund (PPF) might be signalling a ripe time for transferring out of your final-salary scheme.
While switching into a defined-contribution (DC) scheme, which relies on the performance of markets, will mean waving a guaranteed retirement income goodbye, investors will be buying into very low-priced equity markets, and we all know that buying low and selling high is the way to make money. Another pull factor is attractive transfer values which have crept up over the last year on the back of depressed gilt yields.
These factors could see the investment return of a DC or money-purchase scheme match or even beat the benefits promised under a defined benefits (DB) scheme, the technical term for final salary. But to determine if this is indeed the case, Tom McPhail, head of pensions research at Hargreaves Lansdown says a useful measure to look at is the ‘critical yield’. This is the growth rate that the transfer value would have to achieve if it was reinvested into a money purchase pension in order to provide the same income promised under a final-salary scheme.
“A critical yield of 10 per cent demands that your transfer value would need to deliver 10 per cent per annum growth in your self-invested personal pension (Sipp) in order to match the benefits in the DB scheme. This is a big ask and generally we would advise against trying to hit such a high target. We normally work on the basis of an upper ceiling of 6 per cent.”
The risks
Investors seeking out investment flexibility and control might be lured into a money purchase scheme because as Rachel Vahey, head of pensions development at AEGON puts it, this will enable them to become "masters of their own destiny" by setting the right investment strategy for themselves. "Also by transferring they can consolidate their funds into one place, making it easier to monitor and gain an overall view of the amount of retirement income they can expect. It also increases the purchasing power - higher fund values often buy better annuities,” she adds.
That said, there are substantial risks to consider before you choose to opt out of your final-salary scheme. Two of the main investment risks are poor investment performance during the accumulation period and poor annuity rates at the point of conversion into an annuity. The alternative is drawdown, but as John Moret, director of sales and marketing at Suffolk Life points out, this holds its own risk, including longevity risk.
Robin Ellison, a senior partner at lawyers Pinsent Masons adds that there is also the risk that inflation can come back, making it impossible for a re-investment into a personal pension to keep pace with rising prices.
However, Dr Ros Altmann, adviser to the pensions industry, points out that employees being offered an enhanced value for transferring out, could consider moving out of their DB scheme, if the extra cash incentive offered by the employer is attractive enough. “Often, it is also possible to get a higher tax-free cash lump sum from private pensions, than final salary schemes,” she adds.
It is worth remembering that DB schemes provide for a spouse’s benefits, which means your spouse will typically get a proportion of the income in the event of your early death. For individuals who do not have a spouse, there is an argument for transferring out because you are effectively paying for benefits you do not need.
Mike Fosberry, head of financial services at Smith & Williamson, adds that for someone in poor health a long-term pension promise may not be particularly good value. In these circumstances a lump sum transfer value which could be paid to dependants on death, in most cases tax free, may prove an attractive option favouring a move out of DB.
Driver or passenger?
Essentially, the decision comes down to whether you want to be a passenger or driver of your pension vehicle. Transferring into a money purchase scheme will put you in charge of your investment strategy giving you more control and flexibility, but you, and not the scheme, will be taking on all the investment risk. In a DB scheme, you are simply a passenger with no risk liability but also no control should the vehicle crash.
Ms Vahey says to avoid a ‘crash’ members need to consider their employer’s covenant. “How financially secure is the scheme and how strong is the employer? If the employer fails, and the scheme falls into the PPF, chances are the compensation will probably not be as good as the pension benefits given up.”
Mike Morrison, head of pensions development at Axa Winterthur, adds that the PPF cap - recently set at £31,936.32 for those aged 65 - makes it more compelling for those investors with a long service and a high salary to opt out, as they would not have their entire benefit covered by the PPF. “There has also recently been some question regarding the long term viability of the PPF,” he adds.
Nick Fletcher, chief executive of independent financial adviser (IFA) Saunderson House says that deciding whether to transfer out of a final-salary pension is a major decision and one that requires expert financial advice. “For most people, transferring out will not make sense, given the significant value of this inflation-linked income promise.”
Last word
Dr Amarenda Swarup, partner at the Pension Corporation says that ultimately the primary diver for any individual is to secure their pension. He says that pension scheme members should urge their trustees to de-risk the pension scheme in so far as possible by exploring other options that can help secure members’ benefits and mitigate the risk of the corporate sponsor going under. “Insuring the scheme’s liabilities may represent an attractive alternative.”
Colin Melvin, chief executive officer of Hermes Equity Ownership Services adds that members can no longer sit back and passively accept that the future of their pension fund as guaranteed. “I would urge members to write to their trustees, putting pressure on them to deliver accountability and feedback fund information to members. You are after all entrusting them with your long-term wealth.”
