Hundreds of thousands of savers with “final-salary” pensions, which are considered the Gold status of company pensions, are planning to trade in their future guaranteed income for a cash lump sum.
It is estimated that as many as 10pc of the 3.7 million private sector workers who are yet to start drawing their final-salary pensions will choose to forgo their generous guaranteed benefits and take the money as a lump sum instead.
In recent years these generous “gold-plated” pensions, which pay a guaranteed income linked to the worker’s wage at retirement, have become a dying breed.
For millions of workers they have been replaced by the less generous “defined contribution” pensions. With these the employer pays a fixed amount in on a worker’s behalf. What they get at the end depends on investment returns, among other factors, and there are no guarantees.
But the huge attractions of final-salary-type schemes are expected to be outweighed by the new freedoms, first outlined by the Chancellor in his March Budget, which come into force in April 2015 but which only apply to defined-contribution plans.
So to benefit, final-salary members would have to transfer their accrued benefits out of their scheme.
In the past, transfers out of final-salary schemes were generally regarded as unwise. But the sweeping reforms to the pension system mean a transfer could be considered a sensible option for some.
And those willing to risk their money on the stock market could stand to gain hundreds of thousands of pounds from the move.
If someone exchanges a guaranteed defined benefit pension for a lump sum, it can be used as “income drawdown”, a type of pension that allows retirees to carry on investing their pension while taking a flexible income from it.
In certain circumstances it might be possible to “beat” their final-salary scheme.
The new rules are also attractive for those with large pension pots and where inheritance tax looks likely to be payable.
For those with children and grandchildren, the newly amended death benefit rules provide a strong incentive for people who want to bequeath their pension to consider a transfer out of a final-salary scheme and into drawdown. Unlike final-salary schemes (which only offer spouse benefits), drawdown pensions can now be passed to any named beneficiary.
If someone dies before his or her 75th birthday, the remaining pension pot can be passed on entirely free of tax. If the pensioner makes it beyond 75, the beneficiaries can still inherit the pension, but they will pay their marginal rate of tax on the income they take from it. No inheritance tax is payable, regardless of the size of the pension pot.
Another attraction to drawdown is the potential for enhanced investment returns. But higher returns don’t come without added risk, and many retired people, particularly those on tight budgets, will not want or be able to buy riskier assets such as shares.
Research shows investors who are willing to risk their final-salary pension money on the stock market could extract a higher income for the rest of their lives by investing. Take a man retiring at 65 with a £25,000-a-year final-salary pension, for instance. That would give a transfer value of about £625,000.
Say he transfers his pension into a drawdown arrangement, invests it in the stock market and draws the same £25,000 annual income. Assuming the underlying investments grow by inflation plus 2 per cent, he will be able to bequeath around £500,000 tax-free on his death. This would be the size of the remaining pot if he dies at the average age of 86.
However, if the man’s investments had not performed well, the fund would be in danger of running dry.
If his annual investment return, for instance, was consistently 2 per cent below inflation, the pot would run out after just 16 years when the man turns 81. As a result he would need to cut down on his income withdrawals or rely in future on another source of income.
Savers with final-salary pensions need to ensure they are offered an adequate transfer value in return for their guaranteed income.
The transfer value is down to the scheme to calculate, and is based on how long actuaries believe their workforce is likely to need income.
A transfer value will affect someone’s decision to move their money, as some quotes are vastly more generous than others.
For example, if you retire at 60 with a £10,000-a-year pension, your employer or former employer is most likely to offer you a lump sum of around £270,000, 27 times your annual income, calculated in the assumption your will die aged 87.
But other firms may offer someone the same age with the same pension as little as £250,000 or as much as £330,000, according to wealth research. The smaller the transfer value from a final-salary scheme, the more difficult it will be to “beat” it by investing.
John Lawson, head of pensions policy at Aviva, the insurer, warns that in a bid to discourage people from leaving, a large number of final-salary schemes are offering “terrible” deals to people looking to transfer out.
Around a third (29 per cent) of the 3.7 million people with final-salary pensions that allow them to request a lump sum equivalent to the value of their index-linked lifetime income are working in the manufacturing industry, while another 24 per cent are in services roles such as retailers, engineers and administrators.
By comparison, just 0.7 per cent of the schemes will benefit people working in communications, while 1 per cent were set up for people working in agricultural professions. Schemes that are “unfunded”, which means most public sector schemes (for teachers, doctors and Army officers), do not allow transfers out.
To help people sensibly weigh up whether a transfer out of a final-salary scheme could benefit them, the Government has introduced new rules that make it compulsory for people to have financial advice beforehand.
The move is designed to prevent savers making poor decisions about whether to transfer money of their final-salary pension schemes.
For bespoke advice on releasing the money from your pensions contact Credencis.