Your gold-plated final salary pension may lose some of its shine, if the ideas put forward in a new government consultation come to fruition.
In a green paper on the future of defined benefit (DB) pensions, published on Monday, the Department for Work and Pensions (DWP) discusses the option of allowing pension scheme trustees the freedom to change the measure of inflation used to ensure the purchasing power of its members is maintained through their retirement.
DB pensions rise with inflation and guarantee members a certain level of income in retirement. The liabilities of some DB schemes have ballooned in recent years, as members’ life expectancy increases and the yields on gilts and other safe assets have been artificially constrained by QE and low interest rates. With lower interest on offer, more money is needed to keep retirement incomes rising with inflation, but as such schemes are largely closed to new members, finding the extra money is proving difficult. The DWP paper moots the idea of “conditional indexation”, which would suspend inflation-linked increases altogether if a scheme is particularly stressed.
Of course, this is just a consultation. No legislation has been enacted. But pension deficits can oscillate wildly, and can threaten the existence of entire companies, like BHS.
The impact for defined benefit pension holders
Some industry experts think DB pension holders could agree to the measures if they think their retirement income will be more secure. “Although the Pension Protection Fund supports workers and retirees if their scheme goes under, it may pay them less than they might have expected,” said Rachael Griffin, tax and financial planning expert at Old Mutual Wealth.
There are protections placed on any promises of benefits under Section 67 of the Pensions Schemes Act 1995, so “just about the only option is to tweak the inflation proofing applied to members’ benefits in retirement,” said Tom McPhail, head of retirement policy at Hargreaves Lansdown. A number of pension funds have already managed to cut their liabilities by ditching the RPI measure of inflation for CPI, which excludes mortgage interest payments and tends to be lower. Millions of people could be affected if the changes are implemented.
But for those in troubled schemes where increases were frozen altogether, the dent in their retirement income could be massive. According to calculations by Hymans Robertson for the Telegraph newspaper, freezing increases at 0 per cent over the course of an average 25-year retirement could slash a saver’s total income by up to 30 per cent.
For anyone worried their DB pension might be worth less, there is another option – cash in the guaranteed income and invest the cash elsewhere, perhaps in a defined contribution (DC) scheme, or in a self-invested personal pension, which would allow greater flexibility.
“Transferring” a DB pension, as the process is known, is particularly attractive at the moment. Anxious to de-risk their liabilities, the cash values offered by schemes to members looking to cash in their pension have reached record highs. They may not stay there forever. If DB schemes are given more freedom to reduce the levels of payouts as a result of the DWP’s consultation, these generous transfer rates may fall. So should you take the plunge?
Trading in an income for life is not something to do on a whim. If you’re thinking of transferring a pension worth more than £30,000 a year, the law requires you to seek financial advice, which can often run into thousands of pounds. But there are some clear advantages.
Under pension freedoms, the over-55s now have the ability to take 25 per cent of a personal pension as a tax-free lump sum to invest or spend how they like. All income paid by a DB scheme faces tax at your marginal rate.
It depends on your stomach for market volatility, but the flexibility offered by a personal pension may be particularly welcome in today’s inflationary environment, thinks UBS Wealth Management’s Keith Sheehan.
The costs of living in retirement can rise more quickly than the CPI measure used by DB schemes. “If clients think inflation is likely to rear its ugly head for a prolonged period of time, it could be more attractive to take the money out of a DB scheme and invest in real assets which have traditionally gone up in line with inflation, or have provided an inflation-proofing hedge,” Sheehan said in November.
Moreover, DB schemes typically stop paying out upon the pensioner’s death, so unless you buy an annuity, you may be able to pass more of your wealth onto your children after you die if you transfer the cash to a DC scheme. In some cases, your inheritors may not have to pay any inheritance tax.
The bigger picture
However, it is worth noting that DB and personal pensions are treated differently for Lifetime Allowance (LTA) purposes. The LTA limits the amount any individual can hold in a pension without incurring punitive tax charges to £1m. As transfer values have risen, transferring out of a DB scheme offering, say, 30 times the value of your accrued annual pension would push you much closer towards the £1m tax-free limit than if you hadn’t transferred, as the current test to assess the value of a DB scheme sees its accrued value multiplied by just 20.
There are other drawbacks. “The big problem has come where people have taken transfer values, and all they have is a final salary pension,” says Lee Clark, financial planner at Brewin Dolphin. “If you’ve got a wider pool of assets than just a DB scheme, then they can afford to take some market risk,” he says.
Investment solutions are typically designed to track or beat a benchmark, rather than provide a fixed return, as a DB pension would, so any wealth held in a DC pension will be subject to the vagaries of the market.
None of us know exactly how long we’re going to live, which makes it difficult to choose which of your investments to exit and when. For many retirees who have given up work, knowing they will receive a stable income until death can seem more important than control over their own investments.
“Having your money invested in a DC plan means that you have to continue to monitor investments for many years,” said Andy James, head of retirement planning at Tilney. “This may be fine in the earlier years of your retirement, but as we age there tends to be less appetite to continue to review plans and to take investment risk. Even with assistance, when our mental faculties start to let us down, this can be a problem.”