19 Mar Defined benefit pension transfers
In recent years I’ve lost count of the number of times I’ve heard the words ‘I am going to transfer my company pension as it’s worth X’ or ‘my pension is now worth X, and I’ll never live long enough to get that back’. Whether it’s a prospective new client or just a friend down the pub, the recent high transfer values being offered by defined benefit pension schemes has led to a massive increase in the popularity of pension transfers from these schemes.
I’m not saying that all pension transfers are a bad idea, in some circumstances, they make perfect sense, but what worries me is that a lot of people are considering doing this on the back of just thinking that a higher transfer value means it’s a ‘no brainer’. This view is usually supported by dividing the transfer value by the annual pension and getting an idea of how long you need to live to be better off. Unfortunately, the decision on whether to transfer is not as simple as that.
This thinking isn’t helped by the continued ‘assistance’ people are given by financial advisers who have an incentive to ‘sign off’ and provide advice for the transfer. Now I’m not saying all advisers are wrong to suggest pension transfers, but we have seen in recent history (British Steel) that the advice given is not always in the interests of the pension scheme member.
If you are considering transferring your defined benefit pension, take a step back and ask yourself what it is that you don’t like about a guaranteed pension for life with some inflation protection? Obviously, every scheme is different, and some may have funding issues. Still, fundamentally, a defined benefit pension provides an income for life which usually increases each year and provides some form of spouse’s or partner protection on your death. This is with the investment risk, along with the majority of the longevity and inflation risk provided by the scheme. If you transferred, you would have to invest a lump sum and draw an income each year, which comes with all the associated risks which may or may not be suitable for your risk profile. You would also need to: decide on an appropriate asset allocation for the growth rate required to at least provide you with the equivalent annual income that you have forgone; implement a rebalancing strategy to maintain the asset allocation and risk profile of your portfolio; deal with sequence risk when drawing out an income; and have a strategy for dealing with the times when asset prices fall (which they will, probably many times during the long period you are likely to be drawing a pension from your fund), and it may not be a good time to make a withdrawal. Recent history in equity markets is an excellent example of the need to have a strategy for some of these issues.
You might be in a situation where your defined benefit pension won’t provide for the bulk of your expenditure in retirement. Therefore, you might have to deal with these risks and decisions anyway with the rest of your pensions or other assets. So why not take the transfer value and add this to your investment pot?
Apart from the reasons above, which still apply to any defined benefit pension even it is small, you should also consider that having part of your expenditure needs met from a guaranteed source increases your capacity to take on investment risk with the rest of your assets. Not to mention the peace of mind of knowing that some of your needs are going to be met even if all your other investments fall.
Let’s say for example that your expenditure needs are c.£30,000pa for the basics such as food, utility bills, car and other costs that you couldn’t easily reduce if you needed to, and your variable expenditure is another £30,000pa that could be reduced if need be. If you have liquid assets, including a defined benefit pension transfer, of c.£1m these funds are going to need to provide c.£60,000pa ideally or at least £30,000pa no matter what investment returns are obtained. In some years, returns will be negative, and you will have to hold a cash reserve for these years and/or reduce your variable expenditure. This has an impact on how much risk you may need or can take with your remaining liquid assets because as we know, risk and return are related.
However, if you retain your defined benefit pension and this pays you £20,000pa, this will significantly contribute to your basic expenditure needs and should provide you with a minimum income even when investment markets fall. This affects your risk profile and may mean that you can hold a smaller cash reserve and be able to take on more risk with your other liquid assets, hopefully obtaining a higher long term return. The annual defined benefit pension gives you a floor of predictable income, which is valuable for both your peace of mind in retirement and your ability to navigate investment markets.
Neither of these examples includes your state pension, which also provides a level of guaranteed income which, although not a lot, when added to other income does also contribute to someone’s basic needs.
So, if you are considering a transfer of your defined benefit pension take time to consider all the options and in particular how you are going to cope emotionally with relying on investment returns to support your lifestyle in later life. Make sure that you obtain advice and when you do, ensure the advice is based on your goals and overall financial position, not just an analysis of the pension scheme. The process in making the decision should include an analysis not only of your defined benefit pension but needs to include your total wealth, objectives and a financial plan for how you are going to meet your goals given your risk profile and the resources you have available. The plan can then be adapted to show potential outcomes with or without a transfer.