Once seen as the pinnacle of UK pension provision, defined benefit (DB) pension schemes are becoming increasingly rare. A combination of low-interest rates, scheme members living longer, and lower than expected investment returns, have contributed to a rise in the value of scheme liabilities - leading to significant deficits for many DB schemes.
A rising number of DB pension members are now assessing their options to transfer their DB pension benefits, not yet in payment, to a Defined contribution (DC) pension scheme first. Once transferred, this action is irreversible, so how can members approaching retirement understand which option is best suited for their retirement objectives?
What is the difference between a defined benefit (DB) and defined contribution (DC) pension scheme?
A DB pension scheme is set up by an employer and offers guaranteed benefits linked to an employee’s final salary and length of service at the time of their retirement. Costs are generally shared between the employer and employees, but it is the company that remains responsible for any shortfall in meeting the accrued liabilities under the scheme. DB pension schemes are often index-linked to help keep them in line with inflation rates.
On the other hand, it's the member of the DC pension scheme responsibility to build up their pension pot using contributions. Typically, a contribution will be taken from their salary each month, either through salary sacrifice, an employer contribution, or both. The size of the pension pot will also build-up overtime with additional investment returns and tax relief.
If a member of the DC scheme signs up through their workplace, then their employer usually deducts contributions from the member’s salary before it is taxed. An individual may also set up a DC pension scheme on their own. DC pension schemes are not linked to the rate of inflation, so it up to the member to decide how the pot is invested and managed to mitigate these types of investment risks.
Following the release of pension freedoms by the UK government in 2015, almost all the restrictions on how a defined contribution (DC) pension could be accessed were removed. Previously, the vast majority of people had to buy an annuity, and only a few could “cash in” their savings, or remain invested and go into drawdown. This legislation means that members of DC pension schemes have a whole range of options available to them at retirement. This flexibility has become increasingly popular and offers a myriad of options to people approaching or at retirement.
What are the benefits of transferring from a DB pension scheme to a DC arrangement?
We outline some of the key benefits of transferring between the two schemes below;
- Access more flexible income arrangements such as income drawdown
- Obtain a larger tax-free cash sum than available from their DB scheme
- Choose whether to pass on the whole of their fund on death (not just 50% as in most DB schemes)
- Receive improved guaranteed rates on ill-health or
- If they are single, gain access to their pension before “normal retirement age”
- Buy a secure income that starts at a higher level than their DB scheme but which has a lower or no future increases.
What are the disadvantages of transferring from a DB pension scheme to a DC arrangement?
We outline some of the key disadvantages of transferring between the two schemes below;
- Desire to access greater flexibility at retirement may lead to some members choosing to transfer their DB benefits when it is not financially sound for them to do so.
- Large volumes of transfer requests could have a destabilising effect on the original DB scheme.
- Trustees of DB schemes, who must act in the best interests of the beneficiaries, need to be aware of such risks. They need to decide how best to safeguard the interests of their members and the funding position of the DB scheme itself.
- Increasing evidence of attempted pension scams is on the rise. The key to minimising the risk of members falling for such fraudulent activity is to ensure that they are well informed and fully understand all of the options available to them.
Overall, taking no action to support DB members who are contemplating their choices at retirement could leave them exposed to unnecessary risks and unscrupulous scammers. Consequently, trustees need to decide what retirement options the scheme should offer and the level of educational assistance that should be provided to DB scheme members concerning pension freedoms.
How can employers and trustees help members choose the right retirement options?
Clear communication around the issue of pension flexibility, including a member’s right to transfer their DB benefits to a DC arrangement, is vital. Trustees, therefore, need to be able to effectively communicate the member’s options at retirement in a way which does not appear to encourage them into taking a particular course of action that may not be in their best interests. This is a delicate balance to achieve.
Members of DB schemes who are considering transferring their final salary benefits to a DC arrangement are required, in the first instance, to obtain financial advice if they have transfer amounts of over £30,000. Before carrying out any transfer, trustees must check that appropriate independent advice has been received by the member concerned from a professional, suitably qualified, financial adviser who is both independent of the DB scheme and fully authorised by the Financial Conduct Authority (FCA).
Trustees are also expected to check that the appropriate advice has been obtained, by verifying that the financial adviser meets the legislative requirements to carry out the regulated activity, and to ensure that the receiving scheme is a legitimate arrangement. Where trustees have reason to believe that the receiving scheme is not legitimate, the Pensions Regulator advises them to consider carefully whether the transfer should proceed.
However, it is important to remember that requiring members to obtain appropriate independent advice does not make trustees responsible for checking the advice given, the recommendation made, or for confirming whether the member is following that recommendation. Nor is their role to prevent a member from making decisions which they might consider to be inappropriate in that particular member’s case.
Pension freedoms enable DB scheme members to take their pension savings at retirement in any way they choose, albeit by transferring to a DC arrangement first. But along with this flexibility comes greater responsibility on scheme members to plan their retirement wisely. To do this, each individual will need to make sure they have a clear understanding of their own financial situation and needs, so they can be sure the choices they make are the right ones for them. This is where employers and pension trustees can truly help to make a difference.
By providing comprehensive support for their DB scheme members when considering the increased flexibility at retirement, Trustees can help to ensure that individuals have the necessary information to not only understand their retirement options but make better-informed choices for their particular circumstances.
Without such support, there is a danger that some DB scheme members could end up making poor and unsuitable decisions which will directly impact their future wealth and lifestyle in retirement.
So what next?
The ways in which you can deliver financial advice is continually evolving. Currently, one of the most efficient solutions is to utilise a part-customer and part-adviser process.
By providing a secure and impartial area for DB members to fully explore and compare their retirement options if they were to transfer out their final salary benefits, EValue’s Flexible Retirement Options (FRO tool) helps trustees tread the fine line between providing helpful information to members, whilst not appearing to endorse any particular action. It also allows appropriately qualified advisers to directly access these findings and provide mandatory advice in a more cost-effective and efficient manner. This enables trustees to ensure that members who should remain in the scheme understand why this is the case. Also, trustees are able to fully comply with their duty of ensuring that members have taken appropriate, compulsory independent advice where their safeguarded benefits fall outside of the £30,000 exemption.
To learn more about EValue’s Flexible Retirement Options (FRO) tool, please click here or contact us for a demo of our financial software solutions.