Incredibly generous offers made to people with “final salary” pensions have convinced thousands of savers that swapping the guaranteed income offered by these schemes for a cash lump sum is the right thing to do.
Such sky-high “transfer values” are one reason savers are transferring out of these schemes, which also go by the name of “defined benefit” pensions. Flexibility over how you can use your money, including passing unused cash on to the next generation, is a further appeal of transfers to “defined contribution” pensions.
But making the decision to transfer is only the first step.
Deciding when exactly to take the plunge is tricky. Transfer offers typically expire after three months and some schemes will not issue more than one a year, even if you offer to pay.
Pinpointing the best time to transfer is an art as much as a science.
Will your former employer, which funds the final salary scheme, still exist in 20 years? What kind of assumptions on investment returns are being made? And will life expectancy continue to rise?
Below we set out 10 factors that could affect how much your pension fund offers you to quit the scheme.
We assume the transfer value being offered is 22 times the promised annual income, a fairly common multiple. So if remaining in the scheme guaranteed £10,000 (index-linked) a year for life, a transfer would be worth £220,000.
- Long-term interest rates
Yields on government bonds, or “gilts”, underpin both the overall “funding position” of a final salary scheme – the ratio of assets to liabilities – and the transfer values it offers to members.
This is because schemes “discount” offers by the return they expect to make on their investments: the lower the return, the higher the sum needed to pay the pension and hence the higher the transfer value.
In other words, lower expected returns boost transfer values because the scheme needs to set aside more money today to meet its future promises.
Anticipated returns are pegged to gilt yields and Hymans estimated that a rise of just 1 percentage point in yields could see the transfer value for our 50-year-old cut by as much as 25pc.
Gilt yields have plunged to record lows in the years since the financial crisis, pushing up transfer values. But hints in recent weeks that the Bank of England may raise rates have caused yields to rise again.
- Investment strategy
As pension funds have closed to new members they have steadily shifted assets out of shares and into bonds. As a result the expected returns are likely to have fallen.
If a fund moved from having equal parts bonds and stocks to a majority of bonds, that could dampen returns by around half a percentage point a year, for example. This would increase our 50-year-old’s transfer value by 16pc, Hymans estimated.
- Your age
As a rule of thumb, transfer values rise as you near retirement. This is because there is less time for the scheme to grow its assets to meet the promised payments.
If our 50-year-old waited until he was 60 to transfer, the lump sum would be around 9pc higher, all other things being equal, said Hymans. That would mean a transfer value of around £240,000 as opposed to £220,000.
People further from retirement will also find that the transfer value of their pension is more sensitive to fluctuations in interest rates, investment returns and inflation.
- Cost of living
By law, final salary pensions must rise in line with prices. The rules are hideously complex – entitlements built up before 2005 are treated more generously, for instance – but the key point is that if inflation is expected to be higher, transfer values will increase.
Hymans said the 50-year-old’s transfer value would rise by 28pc if assumptions changed to reflect a rise in inflation expectations of 1 percentage point a year.
- RPI v CPI
Depending on the scheme’s rules, your pension will increase in line with either the consumer prices index (CPI) measure of inflation or the retail prices index (RPI), which is normally around 1 percentage point higher.
In some cases schemes are allowed to switch index and many have done so in a bid to cut costs. If our example, if the member had his pension linked to RPI the transfer value would be about 13pc higher than if CPI were used.
- Life expectancy
Final salary pensions pay an income until death. Consequently, the longer the scheme expects its members to live, the more it has to assume it will pay out. If a cure for a major disease were discovered and pushed the average lifespan up by a year, this would raise the average transfer value by roughly 3pc, said Hymans.
- Married or single?
Most schemes provide a “dependant’s pension” that continues to be paid after the original member dies. Usually the amount is half or two thirds of the value of the couple’s pension. Transfer values are based on the assumption that everyone in the scheme is married and take no account of the member’s actual status.
Ms Cooper said that meant single people could find that a transfer represented better value than remaining in the scheme.
- Retirement age
Each scheme sets a “normal retirement age”. If our member’s scheme had a normal retirement age of 60 the transfer value would be around 24pc higher than if it was 65. This reflects the longer time the scheme would expect to be paying out.
Note that you cannot normally transfer once you are within a year of the scheme’s retirement date.
- Weak employer
Trustees have discretion to apply “fair value” to pension transfers. This means that if the company behind the scheme is in financial difficulties or the scheme has a large funding deficit, transfer values can be reduced.
Many readers cite a weak company as a reason to leave a final salary scheme. While it is true that pensions are likely to be cut if the company fails and the scheme falls into the Pension Protection Fund, the transfer value might also be lower as a result.
- Over £30,000? You’ll have to pay for advice
Transfers worth £30,000 or more are not permitted without proof that the member has first seen a financial adviser. While this doesn’t affect the transfer value directly, the cost of advice (which can easily run into thousands of pounds) will take a chunk out of the final amount.
For more information and guidance, contact your nearest GWM Office