Strict rules apply if you have a defined benefit pension – which pays you a set amount when you’ve retired – valued at more than £30,000. Since April 2015, no-one has been allowed to transfer defined benefit pensions of this size without first taking advice.
Since this rule was introduced, data released by the Financial Conduct Authority tells us that requests for financial advice in relation to final salary pension transfers have tripled since new pension freedoms were introduced in April 2015.
This rise might, of course, be at least partly explained by the very fact that taking advice is now mandatory for people affected by the rule. But there could be more to it than this…
A question of freedom
It’s also understandable why more people who have a final salary pension might want to transfer to a defined contribution pension. Final salary pension schemes don’t generally offer the same flexibility as defined contribution pensions – for example, the option of drawing a higher pension for a few years and then a lower pension thereafter. Or the option of passing on unused pension to other family members at death.
The new pension freedoms are attractive, but members of final salary schemes need to consider their decision to transfer carefully. After all, as we discussed in our article Defined benefit pensions – how they work, £1 of final salary pension can be worth over £40 and, in most cases, the transfer values offered are much less than that.
When might it be financially beneficial to transfer?
In some circumstances, it may be worthwhile to transfer final salary benefits to a defined contribution schemes. For example:
- If the transfer value is particularly generous, then it may be possible to buy an even bigger pension from an insurance company. Our article When do annuities make good sense? has some useful reading on this.
- If you’re in poor health. Final salary schemes don’t account for your state of health and you won’t get a bigger pension if, say, you are a smoker or have diabetes. Again, transferring may allow you to get a bigger pension from an insurance company.
- If you’re single. Final salary pension transfer values often include the value of a spouse or partner’s pension within the calculation, even if you don’t have a partner, resulting in a higher transfer value. If you then buy a single life pension from an insurance company, you could end up with a bigger pension.
Another option offered by some final salary pension schemes is a partial transfer, where you transfer only some of your pension to a defined contribution pension such as a SIPP. This means that even if you make poor investment decisions with the SIPP, you at least have some regular index-linked income to fall back on.
As mentioned, it’s compulsory to take financial advice before transferring a final salary pension if it is worth more than £30,000. And, many responsible providers of personal pensions and self-invested personal pensions (SIPP) – where most final salary transfers end up – won’t accept transfers even when the value is less than £30,000 unless advice has been taken.
Transferring from a final salary pension to a defined contribution pension is an important decision, so make sure you understand the implications fully before proceeding.
Employer insolvency and the Pension Protection Fund
Private sector final salary pensions are not guaranteed. Rather, the employer(s) who ‘sponsor’ the pension scheme agree to pay in enough money to ensure that there are sufficient funds to pay the promised pensions.
In the most part, this system works well. However, problems can arise if the cost of providing the promised pensions is significantly higher than the amount of money available in the pension scheme. In these cases, the sponsoring employer will usually agree to a ‘recovery plan’ with the pension scheme trustees, in order to fill this shortfall over a defined number of years.
In extreme cases, usually when the employer has become – or is in danger of becoming – insolvent, the sponsoring employer can’t afford to pay enough money into the pension scheme to close the deficit.
In these situations, the government has set up an insurance scheme, so that members of insolvent employers’ pension schemes don’t lose their pension. This insurance scheme is called The Pensions Protection Fund, or PPF for short.
The PPF usually agrees to take over the running of final salary pension schemes when their sponsoring employer becomes insolvent.
There are limitations on the pension that the PPF will pay out. If you haven’t reached retirement or you retired early then the PPF will pay out around 90% of the pension you would have expected, subject to an age-based cap. For someone aged 60, the cap is around £29,000 and for someone aged 65, the cap is around £34,600.
If you have already retired, at or after your pension scheme’s ‘normal retirement age’, then your pension is protected at the level you are already receiving, again subject to age-based caps. In this situation, the cap at age 60 is about £32,300 and at 65, £37,400.
The Pension Protection Fund does have caps on the pensions it will pay and the rate of indexation it pays may be less generous than your old pension scheme. But it does provide peace of mind to people who have private sector final salary pensions – ensuring that if their employer or ex-employer does go bust, then they won’t be left penniless.