When transferring a pension, whether domestic or overseas into a QROPS (Qualified Recognised Overseas Pension Scheme), International SIPPS (Self Invested Personal Pension Scheme) or similar, the goal is always to get a better deal.
Not all pension schemes are the same so variations can apply to the information below.
What are final salary pensions?
These are pensions where the level of income paid in retirement is based upon an employees contribution history and final salary. A common version is an 80th scheme. The annual income is calculated as 1/80th of the final salary for every year worked. In addition, the policy holder is entitled to 3 times the yearly income benefit as a one-off lump sum payment. For example, an employee who retires with a final salary of £40,000 and 20 years service would be entitled to £10,000 per annum (£40,000 x 20 years x 1/80th) & a one off tax free single payment of £30,000 (£10,000 x 3).
Defined Benefit Advantages
- The income level is guaranteed and not affected by investment performance
- Income paid on retirement usually rises in line with inflation
- Contributions are paid as a percentage of current salary. As a salary may experience substantial increases, due to job promotions for example, contributions made in earlier years may be significantly more valuable than the monetary value originally paid in
- As long as there is sufficient funds within the pension scheme your income is guaranteed
- In the event of a pension scheme going insolvent 90% of the retirement income is guaranteed through the Pension Protection Fund (PPF)
- Prior to retiring, under the assumption that your salary remains in line with expectations, it is possible to know exactly how much you can expect to retire on
Considering all the benefits listed above why would someone wish to change their policy? The alternative, a defined contribution scheme, is in contrast dependant on investment returns to provide an income on retirement. As no-one can predict exactly how investments will perform over the long run there is a risk that this type of pension will not provide sufficient income on retirement. People, however, continue to transfer out of final salary schemes because it can be more advantageous to do so.
Defined Benefit Potential Drawbacks
- Measurements used to determine income on retirement can change. Some examples are: pensionable salary may be lower than your actual salary; the pension age may be increased; and limits can be placed upon future increases so that your pension income doesn’t keep up with inflation
- Retirement income is only guaranteed as long as there is sufficient funds in the holding pension company. If this is backed by the government then there should be no issue but for company held schemes this is a real risk
- A fund may close. Companies can do this to limit the risk of running a fund. There are three options: closing the fund only to new entrants; closing the scheme to everyone thus preventing any future accrual of benefits; and complete closure
- Under the first two methods accrued benefits will still be paid at retirement whilst this may not be the case with a complete closure. Upon the latter the fund is wound up and benefits will only be paid if there is sufficient means. If the scheme can’t honour its commitments it will go bust requiring cover from the Pension Protection Fund (PPF)
- The PPF only covers 90% of pension income up to £36,401.19 at age 65 (from 1st April 2014). This equates to the highest payout level being £32,761.07 per annum
- Payments made through the PPF will only rise in line with inflation up to a cap of 2.5% per annum relating to any pensionable service from the 5th April 1997*
- Payments made through the PPF relating to pensionable service prior to 5th April 1997 will be fixed*
- The PPF is not government backed thus it is possible for payments to be curtailed further
- Your defined benefit scheme may limit when you can retire by imposing a normal retirement age, for example 65. Accessing your pension prior to this age may then be penalised. In comparison, a typical defined contribution scheme will allow retirement from 55 penalty free
- Spousal and dependants benefits on the policyholders death are reduced
- On death of both the policyholder and spouse nothing could be passed on to their heirs versus the remainder of the pension fund in a defined contribution scheme**
- Future pension rule changes may prohibit your ability to change to a money purchase scheme
Potential for a defined benefit scheme to be wound up
To ascertain whether or not there is a chance of any final salary pension scheme failing in its obligation to pay scheme members we can use the top 100 UK companies pension details as a gauge. The following information is according to an independent survey, “LCP Accounting for Pensions 2013”, carried out by Lane Clark & Peacock LLP.
- 88% of FTSE 100 companies had sufficiently capitalised pension funds in 1994 vs 14% in 2012
- The average funding level was 120% in 1994 vs 87% in 2012
- 75% offered final salary pensions to new & existing employees in 2001 vs 1% in 2012
- GlaxoSmithKline & Lloyds Banking Group changed their inflation measurement from RPI (Retail Price Index) to CPI (Consumer Price Index). CPI inflation has typically been less than RPI in the past and is expected to remain the case in the future
- RBS offered members the option to increase pension age to 65 from 60 or to increase contribution levels
- Tesco increased the retirement age to 62 from 60 & changed inflation measure from RPI to CPI
- In March 2014 a flat rate pension was introduced which would take effect from April 2016. This will prevent companies “opting out” of the state second pension, increasing costs and the likelihood of a defined benefit schemes’ demise. Currently most defined benefit schemes are opt out i.e. payment is made to a company’s pension scheme rather than to the Government
- In May, the EU did not introduce “Solvency II” style rules. In effect this would have necessitated FTSE 100 companies paying an extra £200 billion into their pension schemes. This may still be required in the future
- The 2005-2012 allowance for greater life expectancy has added a further £40 billion to the cost of FTSE 100 pension schemes
- A number of companies have capped or frozen increases in pensionable salary
As at company year end 2012;
- Barclays, RBS, BP, Lloyds, BT and Royal Dutch Shell each had total pension liabilities of between £25 billion and over £50 billion. All were increases over 2011
- RBS, BAE Systems, Royal Dutch Shell and BP all had pension deficits for the year of between £3.7 billion and over £6.5 billion
- Babcock International group, RSA Insurance Group, RBS, BAE Systems, BT & International Airlines Group all have pension liabilities in excess of their market capitalisation i.e. their worth
- Median of top 5 companies providing highest funding level was 110% of liabilities. Median of bottom 5 companies was a funding level of 54% i.e. 46% shortfall
Mounting costs are the main concern for the viability of such schemes. With some schemes’ future pension liabilities exceeding the company’s market valuation it is unsurprising that benefits are being continually reduced (using the lower CPI inflation measurement, increasing pensionable retirement age, capping pensionable salary etc).
Should You Transfer?
If you are still contributing to the scheme then it is usually best to remain within the scheme. However, if you are a holder of a dormant scheme you should at least consider which option is best for you.
After weighing up the advantages and disadvantages the key consideration upon which route you choose should be down to the transfer value offered by the final salary pension scheme to move your pension. If this is sufficiently high you should move and vice versa. The middle ground will involve trade-offs so, in that instance, it is more of a personal choice as to which option to go for.
Help can be provided to allow you to make an informed decision. For example, any client considering transferring out of such a scheme at Liberty Wealth would have a matching yield analysis performed. This gives an indication as to how much the transferred pension would have to grow by each year to provide the equivalent pension. If little or no growth is implied then this option may prove tempting for you.
* Information sourced from www.pensionprotectionfund.org.uk/Pages/Compensation.aspx
** During drawdown when the fund remains invested and an income is being withdrawn