Transferring out of your company pension - what are the pros and cons?

Whilst DB pension rights can be very valuable and attractive, they can also be rather rigid and inflexible. For example, a scheme may have a set pension age and although taking an early pension may be possible, it may not be on favourable terms. In this case, taking your pension earlier may mean it is much lower than if you had waited until you reached pension age. Similarly, a scheme may have generous arrangements for married members who leave behind a widow or widower but these may be of no value to unmarried members of the scheme.

If you convert your DB pension rights and put the money into a DC pension instead, then you benefit from the new pension freedoms which allow you much more choice about how you use your money. In addition, the cash amount that you are offered will generally reflect the average cost to the scheme of providing benefits to widows and widowers, so if you are a single person you will get some of the value of that provision which you would not have done if you had stayed in the scheme^5.

In terms of flexibility, those aged 55 and over can now generally access their DC pension pot as they wish. So if you wanted to retire at 60 and live off your savings you could do this with a DC pension whereas you might have had to wait until you were 65 if you had stayed in the DB scheme. Of course, transferring the money does not mean it will last any longer (and indeed if the valuation of the rights is done on a cautious basis you may be losing some value when you transfer). So although you can take your pension earlier under a DC arrangement, you will be spreading the value of your pot over more years than if you had waited until the scheme pension age under the DB arrangement.

Another important aspect of the increased flexibility following a transfer is that you can decide how you want to spread your income and spending through your retirement rather than having a rigid amount throughout. For example, you may take the view that you want to spend more in earlier retirement while you are more mobile and able to travel, and spend less later in retirement, and having a DC pot to draw on enables you to make choices of that sort.

⁵ Of course, if you are married, the opposite argument would apply.

Whilst income from a private pension is subject to income tax, most pensions allow you to take one quarter in the form of tax-free cash. In a DB pension this usually means you get a cash lump sum at retirement plus a lower regular pension than if you had not taken the cash⁶. In a DC pension you can generally take one quarter of your pension pot as a tax-free cash lump sum provided you are aged 55 or over.

One reason why a transfer to a DC arrangement may be attractive is the potential to draw a larger tax-free cash lump sum than if you remained in the DB scheme. If you stay in a DB arrangement you can generally give up a quarter of your pension rights in exchange for a tax-free lump sum. However, the value you get is generally less than a quarter of the value of your pension. This can be for a number of reasons. These include the fact that:

• Schemes have varying rules for how the pension you have given up is converted into an equivalent lump sum and in some cases these can be very ungenerous, especially in today’s low interest rate environment.
• The process of converting from a regular pension to a lump sum is based on the scheme member’s pension only but the rights given up include a potential pension for a widow or widower.
• Complex tax rules can mean that the ^size of the lump sum is reduced relative to the amount of pension given up

One way of thinking about these rates for converting pension foregone into a lump sum is to think about how long you are likely to live⁷. Suppose you expect to live for 20 years and are giving up a pension of £250 a month or £3,000 a year. Over the next 20 years you would receive £3,000 times 20 or £60,000 in pension (excluding the effects of inflation). So if the DB scheme offers you a tax-free lump sum of less than £60,000 you might feel that you are not getting a good deal.

An alternative would be to withdraw your entire DB pension rights and transfer them into a DC arrangement. Once the money is in a DC arrangement (and assuming you are aged 55 or over) you can then take one quarter of the whole pot as a tax-free lump sum and this is likely to be a larger figure than under the DB arrangement. If tax-free cash is particularly important to you, there may be some advantages to transferring out, especially if your scheme is one which offers relatively ungenerous tax-free lump sums within the scheme⁸.

⁶ Some DB schemes are designed by default to give you a lump sum plus a regular pension and may not have the option to take the benefits exclusively as a (larger) regular pension with no lump sum

⁷ A good place to check is the Office for National Statistics website entitled ‘How long will my pension need to last’

⁸ Note that the amount of tax-free cash is potentially larger if you immediately take 25% following the transfer. If you simply put your transfer value into a DC pension some years before retirement then whether or not you get a larger tax-free lump sum depends on the investment performance of the funds between the transfer and when you take the lump sum.

Whether or not it makes sense to stay in your DB scheme may depend in part on who will be left behind after your death and to what extent you want to support them financially. Recent changes in the tax rules on inheritance of certain sorts of pensions have made it more attractive to consider having your pension rights outside the existing DB scheme.

If you remain a member of your current pension scheme then when you die there may be a pension for your surviving widow or widower. If you die very early (perhaps a few years into receiving your pension) your widow or widower may benefit from a guarantee period where the full pension has to be paid for a minimum of (say) five years.

If you are part of a couple but not married, those rights may be more limited but this will vary from scheme to scheme and may be at the discretion of the scheme trustees. And there may also be some pension entitlement to any surviving dependants such as children of school age.

Whilst such provision is welcome and valuable, it does mean that in many cases when you (and perhaps your widow/widower) die, your pension dies with you. In particular there is nothing left to pass on to your beneficiaries. An alternative is to convert your DB pension rights and transfer the money into a pension (if you are still saving) or a drawdown arrangement. In this case, if you were to die, the value of the assets in the pension or investment could pass on to your beneficiaries.

One particularly important consideration is the tax treatment of such money. The rules are⁸  that if you die before the age of 75, then the cash balance left behind can be received by your beneficiaries completely income tax free. Even if you die over the age of 75 then whoever inherits your pot only has to pay income tax in the usual way when they make withdrawals. Furthermore, if your beneficiaries do not draw on this inheritance (perhaps because they already have sufficient income) then it can be passed on to subsequent generations⁹. However, it is worth bearing in mind that present or future governments could change the rules on the tax treatment of inherited pensions at any time if they wished.

⁹ It is worth noting that if you die within two years of a transfer, your adviser or representatives may be expected to prove that they did not know your death was imminent. If they cannot do so, the favourable inheritance tax treatment of the remaining pension pot may be called into question.

One of the advantages of a DB pension is that it lasts as long as you do. But what about people who think – or know – that their life expectancy is likely to be on the short side?

For example, if you draw a pension at 65 and die at 71 then you will not have got much out of the pension scheme compared with someone who lives well into their nineties. DB pension schemes work by pooling risk, and in effect those who live for the longest time are subsidised by those who live for the shortest time. 

If you think you might be one of those whose life expectancy is below average then you might consider taking a transfer out. The value you are offered should (broadly) reflect average life expectancy and this may be a bigger amount of money than the amount it would have cost the scheme to pay your pension if you had stayed in but died relatively young.

If you take your money out in this situation you could simply invest it with a view to your beneficiaries receiving the cash when you die. Alternatively, if you are not concerned about leaving anything behind after you are gone you could buy something called an enhanced annuity. This is basically an income for life, but one which takes some account of your likelihood of dying prematurely. So, for example, someone who has been a chain smoker all their life or who has a serious medical condition might be able to get a relatively generous annuity rate because the annuity provider does not expect to be paying the annuity for very long. One option would be to obtain a transfer value quotation from your current scheme and then find out what annuity you might be able to buy before actually making the transfer. You could then form a view as to which option would give you the better value.

If the employer who sponsors your final salary pension scheme is at risk of becoming insolvent, then there is a chance that you might not get all of the pension you were expecting. But if you transfer out of the scheme then your investment fund will be unaffected by what subsequently happens to your ex-employer’s business.

The way the system works is that if the firm that stands behind a DB pension scheme becomes insolvent, and if the pension scheme is well short of the money it needs to pay all of its future pension promises, then the scheme will be transferred into an insurance-type lifeboat arrangement called the Pension Protection Fund (PPF).

Under the rules of the PPF, those who have already reached the normal age for drawing a pension by the time of the insolvency will get 100% of their pension paid by the PPF, whilst those who are under the scheme’s pension age will get 90% up to a certain cap. Note that what matters is your age relative to the scheme’s pension age and not whether or not you have retired. Read more about how the PPF works. 

One great advantage of having a DB pension is that it lasts as long as you do. If you happen to live longer than average then it is the scheme that has to find the money for this.

By contrast, if you transfer your DB pension rights into cash and manage it yourself, you are taking on the uncertainty about how long you are going to live. There is clear evidence that people tend to under-estimate how long they will live, so there is a risk that you will run out of money prematurely. On the other hand, you may be so worried about running out of money that you draw down the money too slowly and do not enjoy the full benefit of your retirement savings.

You could overcome this uncertainty by buying an income for life (an annuity) but for various reasons this is very unlikely to be as good as the pension you have just given up in your DB pension scheme. Indeed, if all you want is a guaranteed income for life then it is hard to see why you would have left your DB scheme in the first place.

It is more likely that you will go on investing your money and drawing an income from your fund, and the big unknown is how quickly it is safe to withdraw money. There are, of course, things that you can do to manage this risk. For example, if you use the services of a financial adviser, they can help you to review your investments and your withdrawal rate and make adjustments if you are running down your pot too quickly¹⁰.

Whether you are concerned about running out of money too quickly, or about having to be overly cautious about the rate of withdrawal, it is important to understand that these are not problems you would have if you left your money in your DB scheme.

¹⁰For Royal London customers a Drawdown Governance Service is available to advisers which models a range of scenarios about how your investments might do and provides an early warning system for advisers if your strategy needs to be reviewed.

In these days of relatively low inflation, it is easy to forget that over a retirement which could last 20 or 30 years, the value of having an income which has some protection against rising prices could be considerable.

Within your DB scheme the extent of protection against inflation which you enjoy will depend on the rules of the scheme and on when you were a member of the scheme.

To give an example of the importance of inflation protection, let us assume that inflation runs at 2% a year, that your entire DB pension rights are guaranteed to rise by this much, and that you have a 20 year retirement. If your starting pension at retirement was £100 a week, it would be £148.59 by the end of your retirement. Without inflation protection you would still be getting £100 a week – a final pension nearly one third lower.

Clearly the cash transfer value that you are offered will reflect the value of the inflation protection built in to your pension scheme. But once you have taken the cash, all of the inflation risk falls to you. If, for example, inflation were to reach 4% then in the DB scheme your pension would rise by at least 2.5%, and possibly more. So the real year-on-year fall in the value of your pension would only be around 1.5%. But with a DC pension pot a 4% rise in the price of goods represents a 4% fall in your standard of living.

Whilst it is possible to insure against rising prices by, for example, turning your pension pot into an inflation-linked annuity, this is likely to be very poor value compared with the pension that you have given up. Generally speaking, a DB pension scheme is likely to be able to make much more cost-effective provision against the risks of inflation than an individual can do by buying an index-linked annuity from an insurance company. Of course, if you invest your DC pension successfully you may be able to achieve an above-inflation rate of return but the protection against inflation is not guaranteed in the way that it is in a DB scheme.

In short, if you are concerned about the potential impact of rising prices over the course of a long retirement, and/ or about the uncertainty of whether future inflation will be high or low, then staying in a DB scheme is likely to give you both better inflation protection and greater certainty.

When you are a member of a DB pension scheme your money is generally invested in a range of assets. This could include shares, bonds, property, infrastructure assets, commodities and so forth. The value of these different assets can, of course, go up or down. But when you are in a DB pension scheme, the ups and downs of these investments make no difference to the amount of pension you receive – the scheme still has to pay your pension and the employer has to bear the investment risk. You are, in effect, insulated against the ups and downs of investment.

By contrast, if you take a cash transfer and invest the money yourself, the value of your fund can – and will – go up and down. This could have a considerable upside – your assets might appreciate considerably. But there is also a considerable downside risk that your assets will perform badly and you will have to live on a much reduced income.

A key consideration therefore is your attitude to risk. If pretty much all of your non-state pension rights are in your DB scheme and you convert all of them to a cash lump sum to be invested, then you are taking a big risk. You need to consider how you would feel and how you would cope if your investments did badly.

Obviously there are ways in which you can reduce the risk associated with investing in a DC pension or in a drawdown product. For example, you could invest in lower-risk investments but the potential returns may be smaller as a result¹¹.

The key point here is that when you transfer out of a DB pension scheme you are transferring investment risk from your old employer’s shoulders onto your own shoulders.

It is also worth bearing in mind the additional costs which you would face if you manage your own DC pot rather than leaving your rights in a DB scheme. These would include the costs of initial and any ongoing advice you may require as well as product fees and charges. These costs would not arise if you left your funds in a DB scheme.

¹¹There is a different sort of risk associated with having your money in a DC arrangement, namely that the provider may go bust. In this case there is a Financial Services Compensation Scheme which can provide assistance up to a cap. More details can be found at: www.fscs.org.uk.

Since 1997, DB pension schemes have had a legal duty to provide a pension for widows or widowers if a scheme member dies after reaching scheme pension age¹² and many schemes will offer benefits for widows, dependent children etc beyond the legal minimum.

This is a valuable benefit and should not be disregarded lightly. There will also be some rights for widows (from 1978) and widowers (from 1988) under the rules around Guaranteed Minimum Pensions (GMPs) which many schemes had to provide.

Of course, any cash offer which is made to a scheme member will to some extent reflect the fact that the scheme offers benefits to dependants. But because not all scheme members will be married or have dependants, the cash value on offer will tend to reflect the average value of such benefits across all scheme members, including those who will get no dependants' benefits. In simple terms therefore, the amount of money you might get to reflect the fact that the DB scheme offered dependants' benefits would probably be well short of what you would need to buy equivalent benefits if you were to try to do so as an individual.

It is, of course, possible to turn your pot of money into an income for life with an income for your surviving partner if you were to die. But DB pension schemes are generally able to offer benefits of this sort in a more economical way than an individual annuity purchaser is able to. In addition, depending on your surviving spouse’s circumstances, s/he may prefer the certainty of a pension from a DB scheme rather than having the responsibility of managing an inherited DC pension pot.

¹² There are complex rules about survivor benefits for same-sex married couples, cohabiting partners etc and some schemes will do more than the statutory minimum in such cases.

For those with larger pension entitlements, the relatively generous tax treatment of DB pension schemes compared with DC schemes is another reason to think carefully before transferring out of a DB scheme.

Under current tax rules, you can build up pension rights worth £1,073,100 over your lifetime. If you go beyond this you can face tax penalties.

For DC schemes, it is largely a matter of comparing the total amount of money in the pot against the £1,073,100 lifetime limit. For DB schemes, a different (and more generous) process applies. The amount of pension to be paid is multiplied by 20 and any tax-free lump sum is added in. The result is then tested against the £1,073,100 threshold. An example will show that as a result there are situations in which a pension left in a DB scheme could be under the tax limit but the DC equivalent could be over the limit.

Consider, for example, someone with a DB pension at 65 worth £40,000 a year and assume they do not take a tax-free lump sum. Multiplying this by 20 gives a figure of £800,000 which is comfortably within HMRC’s £1,073,100 limit. Now suppose the member asks for a cash equivalent transfer value. The low level of interest rates and the terms of the pension might result in a multiplier of 30 being applied and a CETV of £1,200,000 being offered. If the transfer goes ahead, the member is now potentially at risk of a tax charge on the £127,000 in excess of the £1,073,100 limit.

Clearly in this case the individual has been offered a very large cash sum and the fact that the transfer would result in a tax charge is not of itself a reason not to go ahead. But it does mean that if you have a larger value pension pot you need to be aware that there could be tax consequences of making the switch which need to be taken into account.