What is a Pension Transfer Value?

In order to understand this, you first need to understand that there are two types of pensions in the UK: defined contribution pensions, and defined benefit pensions [1].

Defined Contribution Pensions

Defined contribution pensions are like savings accounts. Money is saved into the pension and invested into assets such as company shares and bonds. The money can then be freely and flexibly accessed once you reach “normal minimum pension age” under UK law (currently 55 [2]) to provide for your retirement. And, the pension provides a number of generous tax reliefs and advantages.

You can usually take up to 25% of your pot tax-free, with the rest taxable as if it were employment income. [1]

If you were to transfer one of these pensions to another, the transfer value is normally the monetary value of the assets in the pension as at the date of the transfer.

Defined contribution pensions are available for individuals direct from pension providers, and also via your employer [1]. They have various intricacies, and some of the tax rules are complex, but it’s generally quite easy to get your head around the basics.

Defined Benefit Pensions

Defined benefit pensions are different. These pensions are only available via employers [1]. Instead of building up a pot of money to fund your retirement, you build up an entitlement to a lifetime income [1] payable once you reach the scheme’s “normal retirement age”, which is usually 60 or 65. This income is guaranteed. If the scheme cannot afford to pay the member their pension, the sponsoring employer needs to top-up the scheme. If the sponsoring employer cannot top-up the scheme because it is insolvent, a statutory public corporation called the Pension Protection Fund (PPF) provides compensation for the member [3].

The amount of income you’re entitled to is calculated as a fraction of your final salary (normally 1/60th or 1/80th) for each year you’ve been a member of the scheme. For example, a member who left their employer’s 1/60th defined benefit pension scheme with 10 years’ service, and who was on a £25,000 annual salary when they left. Their pension would be calculated as £25,000 / 60 x 10 = £4,166.67 [4]. This pension would usually increase a little bit each year to help it keep pace with inflation [5], and “death benefits” may be payable when the member dies [6]. The precise method of calculation (such as the accrual rate and definition of pensionable salary to use), rates of increase, and death benefits are all specified in the individual scheme’s rules, which differ from scheme to scheme.

If the member chooses, they can usually take their pension early (subject to reaching age 55 as a legal minimum) although their pension income will be reduced by an “early retirement factor” to take into account that the pension will be payable for longer [7].

Defined benefit pension schemes usually give scheme members the option to take a tax-free lump sum when their pension starts, in exchange for a reduced annual pension. The amount of tax-free cash available (and the corresponding reduction in annual pension) depends on the scheme’s commutation factor [8].

Defined Benefit Transfers

While there is no “pot of money” to transfer, the income stream payable from the scheme’s normal retirement age for the life of the member, has a monetary value. Its value is calculated as the theoretical current cost to the scheme of providing the future defined benefits to the member. This is what is meant by “pension transfer value” . The correct terminology, however, is “cash equivalent transfer value” or “CETV” for short, so we’ll use this term for the remainder of the article.

Generally, the only people who can transfer their defined benefit pensions are those who have left their schemes (so have stopped accruing benefits). These members are referred to as “deferred” as opposed to “active” – active members have no legal right to transfer.

Additionally, deferred members generally have no legal right to transfer if they are within 12 months of their scheme’s normal retirement age.

Calculating the current cost to the scheme of providing the defined benefits is relatively simple in theory. The calculation has four steps:

  1. Calculate the deferred pension at the date the member left the scheme. As we’ve discussed, this is based on the member’s salary when they left the scheme, the scheme’s accrual rate, and the length of time the member was in the scheme.
  2. Revalue the pension up to the scheme’s normal retirement age, based on the scheme rules.
  3. Convert the revalued pension into a capital sum by dividing it by an annuity rate chosen by the scheme, to give the cost of securing the benefits at the member’s normal retirement age.
  4. This future cost is discounted back to the date of the calculation using a reasonable assumption of future investment returns within the scheme.

This provides the amount of money the scheme needs to set aside now, which will increase in line with investment expectations between now and the member’s normal retirement age, to provide the capital lump sum required sufficient to secure the member’s revalued defined benefits.

If your scheme is underfunded (there isn’t enough money in it to meet its liabilities) there may be an actuarial reduction applied to the CETV. [9]

Guarantees vs. Flexibility

If we were to ask whether you want a guaranteed income for life for your retirement, most people would say yes. And, if we were to ask if you wanted flexibility with your retirement income, they’d most probably say yes as well. However, the two are incompatible by definition. You cannot have 100% guarantees and 100% flexibility. You can have one, or the other, or a mix of both.

Defined contribution pensions offer no guarantees. Their value is dependent on what you contribute and the performance of your investments [9]. However, you have complete flexibility to start, stop, increase, or decrease income as your needs dictate [10]. They also offer significant tax planning opportunities [10] and more attractive death benefits than their defined benefit counterparts [11]. If you want, you can use your pot to buy a guaranteed income for life from a life office. However, you will be sacrificing almost all of your flexibility if you do [12].

Defined benefit schemes are often called “gold-plated” [13]. They provide the member with a guaranteed, inflation-protected income for life [1]. As such, transferring defined benefit pensions into defined contribution pensions is unlikely to be in the best interests of most people. However, some people may have specific objectives they want to achieve that their defined benefit pension is unable to meet, whereas a defined contribution pension may do so. If this is the case, a transfer should be considered.

A financial planner can help you to establish your financial needs and objectives. It is so important to seek advice with pensions given the complexity and life-changing nature of your pension decisions. This isn’t just us who thinks this – if your CETV is £30,000 or more, it is a legal requirement that you seek advice from a suitably qualified financial planner with regard to transferring your defined benefit pension to a defined contribution pension [9].

What Support is Available for DB Scheme Members?

Expert Pensions Advice is a pension transfer specialist. We provide regulated, independent financial advice on pension transfers as part of a holistic financial planning service to help you achieve your financial needs and objectives in retirement.

Before any advice is provided, we will educate you – at no cost to you – on pension transfers (what is known as “triage”) covering subjects such as defined benefit and defined contribution pensions, death benefits, investment, inflation, and the financial planning process. Our Triage takes an hour and is done online.

If, having been through Triage, you want to proceed with regulated advice, we can provide it to you. Or, if having been educated on the subject, you decide you do not need regulated advice, there is no obligation to have it. You can walk away, without the experience having cost you anything, but with proper pensions education which has helped you decide on your own what to do – or not do!

You can contact us via our website www.expertpensionsadvice.com/, e-mail advice@expertpensions.com, or call 07940 228 228.

What Support is Available for Financial Advisers?

If you’re a financial adviser reading this, and you require assistance or support in any of the following areas, we can help:

  • Pension transfer qualification tuition (AF7; PETR; PTPA)
  • Pension transfer CPD
  • Pension transfer advice referrals
  • Technical consultation
  • Pension transfer business support

It can be daunting to start this process, so if you want to speak to someone, we’re only a phone call or e-mail away:

Tuition and CPD

Tel: 01506 657318, hello@expertpensions.co.uk, www.expertpensions.co.uk

Advice referrals, technical consultation, and business support

Tel: 07940 228 228, consulting@expertpensions.co.uk, www.expertpensionsconsulting.co.uk

Bibliography

[1] HM Revenue & Customs, “Types of private pensions,” [Online]. Available: https://www.gov.uk/pension-types. [Accessed 12 01 2019].
[2] HM Revenue & Customs, “PTM028000,” 27 March 2015. [Online]. Available: https://www.gov.uk/hmrc-internal-manuals/pensions-tax-manual/ptm028000.
[3] HM Revenue & Customs, “Pension Protection Fund,” [Online]. Available: https://www.gov.uk/government/organisations/pension-protection-fund. [Accessed 12 01 2019].
[4] Worksmart, “How is the pension paid by a final salary scheme worked out?,” [Online]. Available: https://worksmart.org.uk/pension-advice/workplace-pensions/common-questions/how-pension-paid-final-salary-scheme-worked-out. [Accessed 12 01 2019].
[5] Money Advice Service, “Pension information: guide to the basic facts,” [Online]. Available: https://www.moneyadviceservice.org.uk/en/articles/pension-information-guide-to-the-basic-facts. [Accessed 12 01 2019].
[6] Prudential Technical Team, “Death benefits for defined benefit schemes,” PruAdviser, 30 11 2018. [Online]. Available: https://www.pruadviser.co.uk/knowledge-literature/knowledge-library/death-benefits-defined-benefit/.
[7] Pension Advisory Service, “Retirement Choices Early Retirement,” [Online]. Available: https://www.pensionsadvisoryservice.org.uk/about-pensions/retirement-choices/early-retirement. [Accessed 12 01 2019].
[8] J. Mainwood, “Barnett Waddingham,” 06 08 2014. [Online]. Available: https://www.barnett-waddingham.co.uk/comment-insight/blog/2014/08/06/what-is-commutation/.
[9] Money Advice Service, “Transferring out of a defined benefit pension scheme,” [Online]. Available: https://www.moneyadviceservice.org.uk/en/articles/transferring-out-of-a-defined-benefit-pension-scheme. [Accessed 12 01 2019].
[10] Prudential Technical Team, “Phased Retirement,” PruAdviser, 06 04 2018. [Online]. Available: https://www.pruadviser.co.uk/knowledge-literature/knowledge-library/phased-retirement/.
[11] Royal London, “Death benefits from April 2015,” [Online]. Available: https://adviser.royallondon.com/technical-central/pensions/death-benefits/death-benefits-from-april-2015/. [Accessed 12 01 2019].
[12] Money Advice Service, “What is an Annuity?,” [Online]. Available: https://www.moneyadviceservice.org.uk/en/articles/what–is-an-annuity. [Accessed 12 01 2019].
[13] E. Monk, “Giving up ‘gold-plated’ pensions,” Fidelity, 29 05 2018. [Online]. Available: https://www.fidelity.co.uk/markets-insights/retirement/gold-plated-pension.