According to Insurer Royal London Final Salary Pension transfer values on some schemes rose to an all-time high during 2016. Although a final salary pension transfer will not be the right way forward for the majority and should only be undertaken after an appropriate assessment of the risks and benefits the increase in transfer values and the impact of the pension freedoms 2015 can make a transfer at least worth preliminary investigation.
The Link Between Gilts And Final Salary Pension Transfer Values
Final salary pension schemes tend to use the contributions they collect to buy a long term (safe) income. They use this income to pay pension benefits to those already retired while keeping a close eye on the profile of their future liabilities (those nearing retirement). To secure a safe, predictable income final salary pension scheme managers tend to buy UK Government Bonds (known as Gilts).
In times of economic uncertainty, particularly when inflation is relatively low, investors tend to buy Gilts as they are perceived as a safe investment. This tends to force up the price of Gilts on the open market.
As the price of a Gilt increases, the yield (the income that can be expected from that Gilt) falls – it is an inverse relationship. Since the financial crisis in 2008, the yield on Gilts has continued to fall from approximately five percent in Mid 2007 to an all-time low of less than one percent in August 2016. Major political events, such as Brexit contributed to this fall although there has been a small recovery in yields since the low point.
Partially as a result of low Gilt yields and partially due to the methods used to calculate future liabilities many final salary pension schemes are in deficit. This means the sponsoring employer needs to invest more (sometimes substantially more) into the scheme to ensure future pension liabilities may be met. According to the Pension Protection Fund (in January 2015) from the 6,057, private sector final salary pension schemes surveyed 4,936 were in deficit.
When calculating the transfer value scheme actuaries tend to take account of two main factors. First, they calculate how much it would cost a person to buy the same income provided by the final salary pension scheme if they had to purchase an annuity on the open market. Annuity rates are directly linked to Gilt yield and are therefore also at a low point, hence the higher the transfer value required to purchase the required annuity income.
Secondly, some final salary schemes are prepared to offer incentives (in the form of high transfer values) to members of the scheme to transfer out and thereby reduce the scheme’s long-term liabilities.
The Tax Position
In principle, the pension freedoms (effective April 2015) established that any amount withdrawn from a pension, once an individual reached 55 years old, would be treated as income and taxed accordingly. They allowed an individual to withdraw whatever amount they may require from their pension fund, whenever they may choose. In practice, it is important to note the tax position can be complex and while the Government changed legislation to allow flexibility, not all schemes or providers facilitate this.
Post the pension freedoms, the option to take 25 percent of a pension fund tax-free continued but the 55 percent tax applied to those passing a pension onto beneficiaries after death was abolished. Critically the pension freedoms ONLY applied to those in defined contribution schemes NOT those in Defined benefit (Final salary) pension schemes. A pension transfer from a defined benefit to a defined contribution scheme opens up the potential benefits (and risks) of the pension freedoms.
A final salary pension offers a number of benefits that should not be given up without detailed consideration. Although transfer out of a final salary scheme offers flexibility and potential benefits for beneficiaries there are also risks. A high transfer value can mitigate those risks (to a point) potentially tipping the risk vs reward calculation towards the transfer option. However, each case has to be looked at on its individual merits and a high transfer value does not mitigate all risks.
High transfer values may make a final salary pension transfer an attractive way forward for some but there is no guarantee the situation will not change in the short to medium term. Successive Governments have a history of tweaking (or indeed completely revising) pension and/or tax legislation. Even a small change in Gilt yields could cause a major re-think on transfer values.
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The information in this article does not constitute financial or other professional advice. You should not take action on the basis of this article without seeking regulated independent financial advice that addresses your specific circumstances. Past performance is no guarantee of future returns. The value of your investment is not guaranteed and you may not get back the full amount invested.