25 Wednesday Jan 2017
Defined benefit pension transfer values shoot up 40%
Low interest rates and gilts yields have boosted the value of final salary transfer values.
Workers thinking about transferring out of their final salary scheme have seen the money they receive for their pension shoot up by as much as 40% in the past year as interest rates and gilt yields fall.
Final salary, or defined benefit (DB), pensions are well known for being generous and anyone with a DB pension is typically advised to stay in the scheme. These pensions see employers pay an income in retirement that is based on a multiple of number of years worked and a percentage of the final salary someone receives.
This is in contrast to defined contribution (DC) pensions where the employee receives a pot of money rather than an income in retirement, with the pot defined by how much is paid in and stock market returns.
Those in DB pensions can transfer out of the scheme and receive a ‘transfer value’. This transfer value is based on an actuarial calculation of how much it would cost a person to buy the same income provided by the DB scheme if they had to purchase an annuity on the open market.
For example, if someone had a DB income of £5,000 a year, they would need a pot of approximately £100,000 to purchase that amount of income through an annuity, known as an annuity rate.
Low interest rates
Annuity rates are linked to interest rates and guilt yields, both of which are sitting at historic lows, meaning individuals get even less income when purchasing an annuity.
Interest rates were cut to 0.25% in August after the EU referendum and 10-year gilt yields fell to a historic low of 0.58% in August, although have risen to 0.8% since then.
A Comparison site recentlyhighlighted low gilt yields following Brexit had helped to put ‘considerable downward pressure on annuity rates during 2016’.
While this may be bad news for people with DC schemes wanting the security of a guaranteed income that annuities provide, for those wanting to transfer out of a DB scheme it has provided a boost to their transfer value.
‘Interest rates underpin the cost of buying a pension in the market place and when you look at the transfer of a final salary [the fall in interest rates] has enhanced the transfer value quite considerable over a short period of time,’ said a pension expert.
He said one client had recalculated his transfer value and found the transfer value was worth 40% more than it was just over a year ago.
‘[A client] has seen his transfer value go from £380,000 to £520,000 in the space of 14 to 15 months,’ said Murray.
‘When we looked at it before the numbers did not stack up but having seen such a big jump means it is worth looking [at whether transferring out is a good idea] again.’
An actuary in the UK stated low interest rates and gilg yields had brought transfer values up but the retiree would still have to use the pot to fund their retirement and pay more if they want to purchase an annuity, negating the impact of rising transfer values.
‘You may potentially receive a bigger transfer value but if you have to buy an equal annuity income then you are buying the same thing,’ he said.
‘You still have to do something with that money. [Bigger transfer values are only a benefit] if you just want the cash – you still have to fund your retirement.’
Pike added that transfer fees would not rise automatically in all schemes as reductions were made in values if schemes were underfunded, which may DB scheme are. This means there is not enough in the scheme to cover the cost of the retirement income of all members.
Underfunding of schemes has increased as people live longer and employers have to pay an income for longer than thought.
‘A funding factor comes in to transfer values, and if the scheme is not fully funded there may be a reduction in transfer values.’
Annuities are not the only way to fund retirement since pension freedom was introduced and all retirees can now use drawdown to generate a retirement income, meaning their pension remains invested and an income is drawn from it.
People thinking of transferring not only needed to look at the transfer value but the ‘critical yield’, which sets out the investment returns that would be needed to match the benefits offered by the DB scheme.
‘You apply the critical yield when you are buying an annuity but because we have drawdown now and more flexibility there are more issues to think of,’ he said.
Although Murray admitted that in ‘eight or nine out of 10 cases’, retirees should not transfer out of their DB scheme, those ‘who looked at it recently should look again’.
He added that there were other benefits of transferring out, not just the value, including greater ownership of the money and a better deal for spouses and partners.
‘When someone in a DB scheme dies their spouse or partner only gets half [of the income] they would have received but they receive a greater level under drawdown,’ he said.
‘There is also the ability to pass the money on to kids and grandkids under drawdown [which isn’t possible under DB schemes].’
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