While individual circumstances may differ widely, there are key issues that should always be given careful consideration when contemplating a defined benefit pension transfer. Here we look at 5 of the most important.
1. Capacity for loss
The first issue we consider when assessing the suitability of a defined benefit pension transfer is whether an individual has the ability to take on the risks associated with the transfer. If the pension will be the individual’s only source of income in retirement and the income provided by the defined benefit pension matches their expected expenditure, then they should not take the risk of transferring the pension and the proceeds running out in the future. Therefore a transfer is not going to be appropriate.
However, if we are able to establish a ‘Plan B’ for the individual should the pension be transferred and the proceeds run out in the future, a transfer could be suitable. Examples of a ‘Plan B’ could be having other assets to call upon, downsizing, equity release or future earning potential alongside adequate protection policies being in place.
2. Attitude to Risk
If we can establish that an individual has sufficient capacity for loss to potentially take on the risks associated with a pension transfer, we then look at the individual’s attitude to investment risk. If the individual has a cautious attitude to risk in respect of their finances, it is unlikely they will want to give up a guaranteed index-linked pension in retirement and take on the investment, inflationary and longevity risks associated with a transfer.
However, if they are more adventurous and are happy to accept these risks in the hope of achieving a higher income in retirement, more flexible benefit options or improved death benefits for their family, then it is more likely they will be willing to take on the investment risk required to make proceeding with a transfer in their best interests.
That said, there are also risks of retaining the existing pension scheme. Specifically the financial strength of the scheme should be considered; if the scheme is underfunded, a reduction may have been applied to the transfer value, though there could be a recovery plan agreed with the sponsoring employer which should be reviewed. If the scheme were to fail there would be limited compensation from the Pension Protection Fund (PPF), but at this stage a transfer would not be possible.
If the individual does choose to transfer their pension, appointing an appropriate investment manager and reviewing the pension post transfer regularly would be important.
3. Lifetime Allowance implications
These are another key consideration when contemplating a pension transfer. If an individual takes benefits from their defined benefit pension, this is treated as 20x the pension, plus tax free cash, for lifetime allowance purposes. However, with up to 40x the annual pension being offered as transfer values for defined benefit pensions, this can have a significant effect to an individual’s lifetime allowance position.
As an example, if an individual has a personal pension worth £400,000 and takes their defined benefit pension of £25,000 p.a. (using £500,000 of their lifetime allowance), their benefits would not exceed the lifetime allowance (currently £1,030,000 in 2018/19). However, if they received a transfer value for their defined benefit pension of 40x their potential annual pension (£1,000,000), their total benefits would exceed the lifetime allowance by £370,000 which could result in a lifetime allowance charge of £203,500 (benefits in excess of the lifetime allowance are subject to a lifetime allowance tax charge of up to 55%). It is therefore important to factor in the lifetime allowance implications when assessing the suitability of a potential pension transfer.
4. Death Benefits
The individual’s family situation, health and longevity are important when considering the suitability of a potential pension transfer. If the individual transfers the pension and dies prior to age 75, the transfer value (plus any growth, minus any drawings and/or lifetime allowance charges) would be available to their beneficiaries free from income tax and inheritance tax. Conversely, if the individual takes benefits from the defined benefit pension, their spouse will typically receive a pension of 50% - 66% of the full pension amount, but crucially this will be subject to income tax in their hands. Therefore, if an individual does not have a spouse or civil partner, is in poor health or potentially has poor longevity, a transfer may be more appealing to them (though it should be noted that if an individual transfers a pension and dies within 2 years, there can be unwanted inheritance tax implications).
However, if the individual is married or in a civil partnership and the couple have good longevity, they may feel retaining the defined benefit pension and taking benefits from this is a better option from a death benefit perspective as the spouse’s pension will benefit from the same (often generous) increases in payment as the main pension and upon death at age 75 or older, the death benefits are subject to the same income tax treatment as if the pension is transferred (they are taxable in the recipient’s hands). That said, if the pension is transferred, there is the ability to leave benefits to anyone (not just a spouse), meaning that, as an example, grandchildren could be nominated and income could be drawn in their names (using their personal allowances) to help fund school fees tax efficiently.
The ability to take flexible benefits from a defined contribution pension such as a Self-Invested Personal Pension (SIPP) is often a benefit individuals are looking to take advantage of by transferring out of their defined benefit arrangement. As an example, an individual who is still working could take tax free cash (the value of which may be higher than the tax free cash payable from the defined benefit pension) from a SIPP to pay off their mortgage, without taking any income as this would be potentially subject to higher rate income tax. They can then leave the remaining fund to grow before taking taxable income from the pension in retirement, when it may only be subject to basic rate income tax.
However, if the same individual wanted to take tax free cash from their defined benefit pension prior to the normal retirement date, their benefits would have an early payment applied to them and taxable income would need to commence straight away, which would not be income tax efficient.
For any enquiries regarding defined benefit pensions, please contact Alex Shields (firstname.lastname@example.org) on 020 7633 2222.