There has been much written in the media lately about the increasing number of transfers from DB (Defined Benefit) pension schemes into unsecured pension arrangements such as SIPPs and Personal Pension Plans.

This type of transfer is where an individual gives up all future rights to an index-linked pension that is virtually guaranteed by a DB scheme, and transfers the cash equivalent transfer value to a SIPP or Personal Pension Plan. Here the future amount you can draw and longevity of the pension is totally unguaranteed: it is dependent on the UK and global economic forces that drive the performance of investment markets, gilt yields and interest rates.

And, as we all know from past performance, the value of these sorts of investments can go down as well as up.

So, given that most individuals would normally bite your hand off for any type of investment that offers a good level of guaranteed income, why are so many of these transfers taking place today?

Record low gilt yields are driving transfer values up

As always, some of the reasons are fairly straightforward while others are more complex, but one key driving force appears to be the current elevated level of the transfer values being offered by some DB Schemes.

These schemes need to match their long-term liabilities – i.e. the guaranteed pensions they must pay out both now and in the future, with a range of secure assets such as Government bonds. When the yield from such assets falls, the cash equivalent required to provide the guaranteed income increases and in many instances the transfer values will respond accordingly.

To explain how that works in simplistic terms: say your current pension is paying you £10,000 a year and that was based on a pension pot of £200,000 providing a return of 5%. If the returns you can expect to receive go down to 4%, that would require a pension pot of £250,000.

Recently, bond yields have been extremely low and in some cases, transfer values have risen dramatically.  The Xafinity Transfer Value Index tells us that a DB scheme member currently entitled to a pension of £10,000 each year, starting at age 65, would typically expect to receive a transfer value of £243,000. This compares with a transfer value of £205,000 available in January this year.

Given all the media attention you may think that there has been an across the board increase in transfer values – but this is simply not the case. 

Many DB pension schemes are actually in deficit, which in simplistic terms means that their long-term liabilities are greater than the pension scheme assets, and for these schemes the transfer values can (and often are) adjusted downwards. 

Pension freedoms allows better access to planning withdrawals

The advent of Pension Freedoms in 2015 heralded flexible income withdrawals and the potential for estate planning, and that is also a key driver in the rise in transfers out of DB schemes. 

A spouse’s income is automatically built into many DB schemes, typically at the rate of 50% payable on the member’s death member’s income, and some schemes also provide children’s pensions. However, if the member is unmarried with no dependant children this benefit is worthless and there is no ability for the member to exchange it for a higher member’s pension.

Even where a member is married and/or has dependant children, he or she may already have adequate finances in place to provide for the family on death. So the ability to transfer out to a SIPP or Personal Pension Plan and build a flexible succession plan that could include a single or series of tax effective cash payments to family members, and/or a range of other potential beneficiaries, becomes a powerful estate planning feature.   

Don’t throw caution to the wind

Clearly the ramping up of transfer values as a result of falling bond yields has become very seductive – not only for pension scheme members but for advisers too!

There are other advantages to transferring, such as flexible withdrawals and income tax planning… but there are significant potential pitfalls too.

In simplistic terms, if the transferred pot of money is needed to provide a specific level of income to pay the monthly bills, perhaps at the level of an annuity, then it is very likely that the DB pension remains the best option – even for a single person.

It is very expensive to purchase a fixed income that increases year on year from any financial instrument, yet this is exactly what your DB pension will provide for you – throughout your lifetime.

As seductive as the value of your DB transferable value may sound, it is vital to seek professional advice before embarking on a DB pension transfer – and indeed advice is mandatory where the transfer value is greater than £30,000. 

There are many specialist practitioners out there who will be delighted to help, but the fees are fairly hefty – both for the initial advice and for the ongoing management of your pension pot – and these can be a drag on the performance of your newly invested pension fund.

And of course, that’s something you shouldn’t need to worry about with a DB Pension.   

So what does the future hold?

Currently, across the board, it is considered that a DB transfer may be worthwhile looking at for between 10-15% of all DB pension holders. Very often this is because the total loss of a guaranteed pension income is too great a risk to bear for the 85 – 90%.

One of the big problems cited by many DB administrators and personal pension providers alike is the rigidity of the DB Pension Scheme rules. These usually state that a transfer value must be taken in its entirety or not at all, and some schemes even impose an embargo on providing transfer values no more than once a year.

These problems may be easily circumvented by a simple change to the scheme rules and there are signs that Scheme Trustees and their administrators are being more responsive to market demand: a small but increasing number of DB Schemes are now offering partial transfers out. This could be a win/win situation, with the scheme member achieving some flexibility whilst retaining some level of guarantee, while the pension scheme reduces its liabilities going forward.  

We will have to wait and see if this catches on!

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