Rarely out of the news, we discuss final salary pension schemes and why a number of advisers are taking another look at this formerly untouchable pension pot as some Cash Equivalent Transfer Values (CETV) hit ‘all time highs’.
What is a Final Salary Pension Scheme?
A final salary pension, occupational pension, defined benefit (DB) schemes or the good old company pension – there are many a name for something which has been synonymous with ‘comfortable retirement’.
A promise of a certain level of pension upon retirement. This is usually calculated by the number of years in service , divided by the ’Accrual Rate’ a fractional amount e.g. 1/60th, 1/80th 1/120th, and so on, multiplied by the final salary in question. This final figure is the expected pension per annum.
Pensionable service: 25 years
Final Salary: £35,000
Accrual Rate: 1/60th
Pension: £14,583.00 Per Annum
Formerly regarded by many as the holy grail of retirement income, outside of the public sector they are now few and far between with many schemes closed off to new members and, in some cases, a cap imposed on those accruing benefits. The tide has begun to turn against some schemes following near negative interest rates and the less than positive financial press coverage.
So why has the gilded bubble burst, or at least deflated, leading some financial advisers to take another look at their clients’ schemes and, in some cases, recommending a transfer?
The Pension Deficit
The Pension Deficit is the widening gap between the employers pension bill and their ability to pay out. This chasm is only becoming greater as life expectancy increases and the yield from gilts falls, both of these factors combined take a majority stake in the blame, leaving the employer with a black hole to fill to meet the specifications of the final salary agreement.
In the Media
This ‘crisis’, as is has been dubbed in the media, has been played out in full view of the public with BHS as a highly ridiculed example of a scheme gone awry. The DWP and the Pensions Regulator fairing only slightly better than their much maligned former chief executive. Similarly, the former employees of Tata steel, who’s £15 billion scheme has been passed from pillar to post with no one willing to take on the bill, has left the employees in a no-man’s land. The size of the problem is huge, with figures from the Pensions Protection Fund (PPF) reporting that 4,993 of the 5,945 UK defined benefit schemes are in in deficit as of October 2016.
What Protection is There?
The widespread publication of BHS’s failure to adequately account for a long-term plan for pension payment protection by the employers themselves, also indicated the need for government intervention, in such cases. Thus far, those in final salary schemes have been placated by the implementation of a ‘safety net’, launched 11 years ago, in the form of the PPF. This offers protection to scheme members and will continue to pay members’ benefits subject to the scheme rules, which limit benefits in some scenarios.
Could BHS crisis spell the end of The Pension Protection Fund?
With BHS having a reported £571m pension deficit, the enormity of this number could have the public believe that the PPF may be sunk by such a huge bill. Fortunately, that is not the case. However, it would be arguably naïve to assume that the safety net is not finite and that future workforces. Will those who fall victim to a BHS style implosion all be welcomed aboard the PPF life raft? Tata steel workers are currently at a crossroads, one which could lead them down the route scheme protection by the PPF – at a cost estimated anywhere between a 10-25% cut to the pay outs.
Should Your Clients Consider a Transferring their Final Salary Pension?
Transferring a client’s final salary pension was formerly unthinkable for most cases. However, there are now a number of financial advisers who are taking another look at their clients’ final salary schemes and making a different recommendation to one which may have been issued in the years prior. We take a look at three of our own case studies, and their different reasons for deciding to transfer.
Case Study 1 – Interest Rates
Changes in accounting standards led many pension fund managers to invest in gilts, low-risk British Government backed units of debt. Low risk, yes, but notoriously low levels of returns.
Now we are in an age of interest rates hitting an all-time low, linked to the fall in gilt and corporate bond yields, this has had a positive effect on the CETV offered, upon re-visitation of the original value, for some clients. In one case study for a True Potential client, the original CETV valuation stood at £245,000 in October 2015. Reassessment of this in July 2016, was £303,000.
That is an increase in value of 23%.
Case Study 2 – Personal Circumstances
Not confined to the benefits presented by the fall in interest rates and their positive impact on transfer values, personal circumstances should also be a taken in to account when considering a transfer.
For another True Potential client, this played an integral part in her decision.
- A long standing service of 29 years with a high street bank
- Age 55 and divorced
- 2 grown up non-dependant children
Before Pension Freedoms were introduced, what were the client’s options?
Planned Retirment Date: 21 April 2021
Option 1 – full pension only – £31607.60 per annum
Option 2 –Tax free lump sum £151,360.34 + reduced pension – £22,704.05 per year
Transfer Value: £762,940.30
If the client had chosen to remain in her final salary scheme, taking either option one or two, as a divorcee, she had no spouse who upon her death would have been entitled to receive 50% of this income. With two grown-up children, should the client have passed away, their entitlement would have been £0. This demonstrates the personal implications and limitations of final salary schemes, should the worst happen.
This hypothetical scenario had a marginal impact on the client and her decision to transfer. Upon implementation, the the clients’ tax-free lump sum grew to £190,735. This allowed the client to pay off some outstanding debt and thus increased her disposable income by £15,624 per annum as well as the potential for the full pension fund value could be left to her children upon death.
Case Study 3- Lower Final Salary
The benefits of transferring some schemes are not restricted to those with high final salaries. In our third case study, the client in question held 20 years of service at a high street bank, with a final salary of £18,000. Her total employee contributions over a 20 year period had amounted to £13,500. When seeking advice, the transfer value was £376,262.
The Impact of Pension Freedoms
For those who are taking another look at their client’s final salary schemes, this has been facilitated by the increased pension freedoms. Pensioners have more options and flexibility in the ways in which they draw, invest and spend their pension pot. With these great freedoms, comes great responsibility. Adequately accounting for a retirement income to meet expenditure is one which should be thoroughly considered and thought-out, by all clients. Seeking final advice is not only sensible, but is a requirement for pots of over £30,000.
Cases for clients with a final salary pension, may be worth reviewing upon the basis of these factors. If you think this may apply to your own circumstances, you should speak to your financial adviser about your options.
Your capital is at risk. Investments can fluctuate in value and you may not get back the amount you invest. Past performance is not a guide to future performance. Tax rules can change at any time.