Final Salary pensions schemes, also known as Defined Benefit (DB) schemes, have long been held out as the gold standard of retirement provision.
It’s true that, if the pensioner lives a long time, they will provide a high total return.
If, however, the pensioner lives a short time then only a small part of the transfer value will have been received as benefit, and no further payments would be due.
Looking at a simple example, James, age 65 has the choice between a DB pension of £4,000 a year or a transfer value of £100,000.
If James died within five years of retirement in the DB scheme he would have received less than £20,000 and, if he was single, no further sum would be payable. It would take 21 years before more cash has been received than the £100,000 offered as the initial transfer value.
If James took the £100,000 transfer option, assuming an average annual investment growth of 4% and fund charges of 1%, even if he still takes £4,000 per year, there would be around *£67,000 left over at age 85.
DB schemes are also criticised for a lack of flexibility, in that they simply allow a person to take an initial tax-free lump sum and then provide a relatively fixed income each year, increasing in line with inflation. They offer no opportunity to draw additional income in retirement.
This goes against many pensioners’ lifestyles.
Typically, people need more money to spend in the early years of retirement when they remain active plus, in many cases, a lump sum may be needed to cover years of high expenditure if or when care costs arise.
Since the introduction of pension freedom, there has been an increase in the number of people considering a transfer from DB schemes into a personal pension but the number of people actually doing so is still very small.
Why is this number so small when more than half the members of such schemes would eventually receive more cash following a transfer than they would by just drawing the DB income?
Obstacles to moving
The main obstacles to moving from DB to DC are:
- The Financial Conduct Authority (FCA) actively discourages it, which means many advisers avoid the issue.
- The cost of the advice that must be taken for schemes over £30,000 is expensive.
- A lot of people do not realise these options are available. Many people in DB schemes have never thought they needed financial advice.
- It does involve an element of risk that would not be present in a DB environment.
- Trustees of the pensions schemes generally view transfers unfavourably.
Trustees currently have no obligation to spell out the options available to retirees, yet the FCA has put rules in place for those who run personal pensions to ensure plan-holders are encouraged to shop around. If pension freedom is to be applied to everyone equally, surely something similar is needed in the DB world.
Until then perhaps, financial advisers should consider discussing the risks and the benefits of a move from DB to DC to engage a customer base that thought it didn’t need financial advice.
(* simple mathematical calculation for illustration purposes only)