Should I transfer out of my final salary pension scheme?

The final salary pension scheme I'm in is in trouble because there's a big deficit. I'm wondering whether to transfer out, but is that a good idea?

The final salary pension scheme I'm in is in trouble because there's a big deficit. 

I'm wondering whether to transfer out, but is that a good idea?

Pension worry: Should you leave your employer's final salary scheme if you think it's in bad financial straits?

Pension worry: Should you leave your employer's final salary scheme if you think it's in bad financial straits?

Tanya Jefferies, of This is Money, replies: Many final salary pension schemes are in deficit and it is understandable to be worried if the one where you work is underfunded.

This doesn't necessarily mean your future pension is at serious risk though, as your employer is legally obliged to keep funding its final salary scheme for as long as it stays in business.

If an employer is really struggling under the burden of its pension scheme, it might try to negotiate with workers to increase their individual contributions or accept lesser benefits like a later retirement age. 

However, they are limited in what they can do on this front by regulators and the existing contractual terms of their schemes. 

So, your employer will have to continue propping up your pension scheme unless it goes bust. Yet, even in that worst case scenario, responsibility for paying your pension would pass to lifeboat scheme the Pension Protection Fund.

HOW BIG ARE FINAL SALARY PENSION DEFICITS? 

Many of the UK's 6,000 private sector final salary schemes have struggled with deficits during years of record low interest rates and rising life expectancy.

The total deficit of all private sector final salary schemes was £420billion at the end of July, although this was down from around £610billion a year ago due to financial market fluctuations, according to PwC’s Skyval Index.

This calculation was based on the 'funding' value of liabilities to pension savers, which is used to determine what companies must pay into them.

A separate report by actuarial consultants LCP said FTSE 100 companies had paid around £150billion into their defined benefit schemes over the past 10 years.

However, despite these funding injections the 'accounting' value of liabilities shown in their company accounts has worsened from a £12billion surplus to a £17billion deficit during this period due to falls in bond yields.

Read more here about how the crisis facing final salary schemes blew up and some solutions being put forward. 

It pays a full pension to scheme members who are already retired, and 90 per cent to those still saving up to a cap which is explained below.

When it comes to transferring out of a final salary scheme, many people consider doing this nowadays even though it will mean giving up a typically generous and guaranteed income from retirement until they die.

This is because some are being offered gigantic transfer values - often worth vastly more than the current size of their pots - by employers keen to clear the obligation to pay expensive final salary pensions off their books. 

But if your scheme is underfunded, it might make a much stingier transfer value offer to you.

Others want to ditch a final salary pension because of the desire to invest their savings in the hope they will continue to grow, and the opportunity to leave whatever is left over to loved ones when they die. 

However, because of the valuable guaranteed income you lose by transferring to a defined contribution pension - where you and an employer save money in a pot that's invested for retirement - the Government has made it compulsory to get financial advice if your transfer value is £30,000-plus.

We got a financial expert to explain what you should weigh up before leaving a final salary scheme, and asked the Pension Protection Fund to outline what happens if your employer goes bust and it ends up paying your pension instead.

Ian Browne, pensions expert at financial services firm Old Mutual Wealth, replies: Transferring out of a defined benefit pension scheme is a major undertaking.

Defined benefit - also known as final salary - pension schemes differ from other kinds. This is because a scheme has to provide members with a guaranteed income for life from the point of retirement and this income is inflation proofed.

Even a relatively modest defined benefit pension income of £15,000 a year would cost somewhere in the region of £600,000 if you were to purchase an equivalent secure income product from an insurer.

Although there are some sensible reasons for transferring out, the stability of the scheme or the sponsoring firm would not normally be the sole reason to transfer.

Ian Browne: 'Transferring out of a defined benefit pension scheme is a major undertaking'

Ian Browne: 'Transferring out of a defined benefit pension scheme is a major undertaking'

What does it mean if your pension scheme is in deficit?

Defined benefit schemes typically have tens or even hundreds of thousands of members. They will have built pots of assets worth billions of pounds from which to pay pensions to scheme members.

Although this is an expensive exercise the resources do exist to meet a pension scheme shortfall. In 2016, FTSE 100 companies paid four times as much to shareholders as they did in contributions to their defined benefit schemes.

Thankfully these schemes are well regulated and have to prove they have a recovery plan in place if they have a large deficit.

Despite this, there will always be situations where, because of insolvency, the employer is unable to fund the scheme benefits. This is why the Pension Protection Fund exists. It is a government-backed scheme which acts as a form of insurance. The PPF pays pensions to existing and former staff if a sponsoring employer becomes insolvent and cannot do so.

There are currently over 6,000 private sector defined benefit schemes in the UK. Around 880 schemes and 235,000 members have transferred to the PPF to date, with total claims on it amounting to around £5.5billion. 

The Government has predicted that another 600 schemes and around 150,000 members will transfer to the PPF by 2030.

What happens if you decide to transfer out?

Moving out of your defined benefit scheme means going into a defined contribution pension. If you do transfer, responsibility for your pension will pass from the employer to you.

HOW DO DEFINED CONTRIBUTION AND DEFINED BENEFIT PENSIONS WORK? 

Defined contribution pensions take contributions from both employer and employee and invest them to provide a pot of money at retirement.

More generous gold-plated defined benefit - or final salary - pensions provide a guaranteed income after retirement until you die.

Pension freedoms launched in 2015 allow over-55s greater control over their pots, but only apply to people in DC schemes.

Those with DB pensions can transfer their savings to DC schemes, provided they get financial advice if their pot is worth £30,000-plus.  

That means managing the pension investments on an ongoing basis will be your responsibility, as will bearing all the investment risk through the ups and downs of financial markets.

That job would continue during your retirement years, unless you purchased guaranteed income via an annuity, which would prove expensive compared with giving up the guaranteed income from your defined benefit pension, as explained above.

You will need to consider a whole range of factors before making a transfer to assess whether the benefits of moving to a defined contribution scheme outweigh staying in your defined benefit pension.

The right thing to do depends on your specific circumstances and requirements, like how much you value the flexibility of a defined contribution pension, for example, or whether you have any other forms of secure income in addition to the defined benefit fund.

Your concerns about the scheme’s solvency may form part of this consideration, but your pension would ultimately be protected by the PPF if it did become insolvent.

A financial adviser will be able to help you review these matters. Government legislation makes it compulsory for people to get independent financial advice if they want to move a defined benefit pension with a transfer value of £30,000 or more.

What else should you know before making a decision?

Sara Protheroe, chief customer officer at the Pension Protection Fund, says: Planning for retirement is difficult at the best of times, and knowing your final salary scheme is underfunded can sound concerning.

But it’s important not to panic and transfer out of your final salary scheme just because of this. There are some important points to consider and you should always seek independent financial advice before making such a big decision.

Sara Protheroe: 'If the worst does happen to your scheme and your employer goes bust, the Pension Protection Fund is there to protect members'

Sara Protheroe: 'If the worst does happen to your scheme and your employer goes bust, the Pension Protection Fund is there to protect members'

As long as the employer standing behind your pension scheme is solvent, the pension scheme should be able to continue paying your full pension. The Pensions Regulator oversees this.

By contrast, if your scheme is underfunded and you decide to transfer out, your transfer value may be reduced to take account of this underfunding, so you could lose some of the pension you are expecting.

What happens if your employer can't pay your pension?

If the worst does happen to your scheme and your employer goes bust, the Pension Protection Fund is there to protect members of eligible schemes - the vast majority of private sector schemes - meaning you would receive compensation for your lost pension.

Your scheme pays an annual levy to the PPF – a bit like an insurance premium to provide for the scheme’s members if it can no longer fulfil its obligations.

It’s worth bearing this protection in mind when thinking about your pension. It may be worth more than you would receive if you transfer out of an underfunded scheme.

You don’t need to apply for PPF compensation. Schemes whose sponsoring employer have gone bust enter the PPF if there isn’t enough money in the scheme to pay people more than the PPF would. The PPF takes on the assets of the scheme and pays compensation to members.

If you’d already reached your scheme’s normal pension age by the time your employer went bust the PPF would pay 100 per cent of your pension.

If you hadn’t reached your scheme’s normal pension age when your employer went bust, the PPF would pay 90 per cent of what your pension was worth at the time, up to a cap. This cap is currently just over £38,500 per year for someone retiring at 65, so it only affects the highest earners.

What about inflation, death benefits, early retirement and tax-free lump sums?

Payments relating to the pension you’ve built up since 5 April 1997 would rise in line with inflation each year, up to 2.5 per cent. Payments relating to service before that date wouldn’t increase. Your family would also be entitled to certain levels of compensation after your death.

You can still take early retirement and a tax-free cash lump sum if your scheme enters the PPF, and how the PPF calculates these can sometimes be more generous than a typical scheme.

It’s also worth knowing that the PPF is in a strong financial position, so if you’re in a final salary scheme you can be reassured that the PPF will protect your pension should your employer fail.