When does the new freedom available to DC members outweigh the guaranteed promise of DB pension? Read on to see what could tip the balance in favour of some clients switching to DC before taking their benefits.
An example case study to illustrate the issues in a context to help you understand the wider parameters influencing a recommendation to transfer:
Harry is 58 and a senior executive on the Board of a large private bank, where he has worked for most of his career.
He has a generous benefits package, which includes membership of the bank’s final salary pension scheme. This is his only pension benefit. He became a deferred member of the scheme, leaving on 5 April 2014 so he could elect for fixed protection, ‘fixing’ his lifetime allowance (LTA) at £1.5m. This seemed a reasonable thing to do, as Harry is hoping to retire next year when he turns 60 and it’s likely that the extra protection against LTA tax, and his early leaver revaluation, will outweigh the value of continued DB accrual.
His deferred pension is £75,000 a year. This is inflation proofed, and also provides for a 2/3rds widow’s pension. He recently requested a transfer value and this came out at £2m.
Harry is married to Zara, 53, and they have three adult children and two young grandchildren.
Zara has her own career and intends to carry on working when Harry retires. She has also built up her own pension through occupational money purchase schemes.
Harry wants to retire at 60, his normal retirement date under the final salary scheme.
Between them, Harry and Zara have a variety of investments, including ISAs, shares, collectives and three rental properties which produce a healthy level of income. Their joint estate is valued at around £5m, so estate planning is high on their list of priorities.
Harry has always valued the security of income that his ‘gold plated’ scheme will provide. But pension income is not the ‘be all and end all’ for Harry. He has income and capital available from other sources. And with the opportunities available under the new era of ‘pensions freedom and choice’, he’s wondering if there’s a better fit for his family circumstances.
Harry’s adviser helps to outline the pros and cons of retaining his final salary benefit, against transferring to a Self-Invested Personal Pension (SIPP). The decision is more than a comparison of the promised final salary pension income with yields that could be achieved from funds transferred to a SIPP. This is because of what SIPP flexi-access drawdown can offer in terms of income flexibility, control over income tax and the ability to create a tax-efficient legacy. In Harry’s circumstances, this flexibility might better meet his needs (and those of his family) than a fixed final salary pension.
Further, current gilt yields are at historic lows, which are providing enhanced transfer values, with reduced yields required from SIPP funds to match scheme benefits. However, an investment return is not guaranteed from a SIPP, but an annuity could be bought with some funds, at a later date, when interest rates rise significantly from current levels, to secure a basic level of income requirement.
The key considerations are:
RETIREMENT BENEFITS FOR HARRY
An annual pension of £75k, fully inflation proofed, for the rest of your life.
The scheme does give the option of commuting some pension for tax free cash, but you have decided that the terms on offer don’t represent a good deal.
An investment pot of £2m, which can be accessed at any time. An initial annual return of 3.75% would match the final salary pension (£2m x 0.0375 = £75k).
No investment choices need to be made. In the event of the scheme becoming insolvent, your benefits should be protected under Pension Protection Fund once they’re in payment.
Investments will need to be regularly reviewed to manage returns and volatility. The low yield needed to match the final salary pension means this should be achievable within a moderate risk tolerance.
LIFETIME ALLOWANCE CHARGE
The crystallised value will be £1.5m (20 x £75k), and so within your protected LTA.
Fully crystallised, the fund will exceed the LTA by £500k. The LTA charge will only be applied once benefits are crystallised above £1.5m, on reaching 75, or if you die before 75. So there is some degree of control over when this happens.
FLEXIBILITY AND TAX
As your pension is fixed, part of this income and all of your savings income will be taxed at higher rates of income tax, and capital gains taxed at the higher rate of 28%.
Income not required will accumulate and add to your potential IHT liability, unless given away. Such gifts may be relievable under the ‘normal expenditure out of income’ exemption.
Using flexi-access drawdown gives you complete flexibility over how and when (or even if) you take taxable income from your pension.
So amounts withdrawn can be made in sync with the fluctuating income from your investments and your spending needs. And your tax liability can be managed by phasing tax free cash and income, taking just Tax Free Cash (TFC), or just income from the crystallised pot. You will only be taxed on income taken from the ‘income’ pot.
The scheme cannot provide you with any additional ‘emergency’ funds, should they be needed.
All your savings can be accessed at any time should funds be required.
Death benefits for the family
BENEFITS FOR YOUR BENEFICIARIES
These are limited to a widow’s pension for Zara, currently worth £50k a year, fully inflation proofed. And this pension is taxable.
But if Zara pre-deceases you, there will be no pay out at all.
On your death, the remaining pension fund can be nominated to ANY of your family members (or anyone else for that matter) to benefit from.
Uncrystallised funds will be tested on death against your available LTA.
Your beneficiaries can choose to access their inherited pension at any time. And it will be tax free (up to the available LTA) if you die before 75.
BENEFITS AFTER DEATH OF YOUR BENEFICIARIES
Your children will inherit nothing from your pension at any stage.
The health of you and Zara will therefore play an important part in deciding whether remaining in the final salary scheme will give you, and your loved ones, value for money.
Any of your nominated beneficiaries can later pass on their inherited pension fund to their own chosen successors.
Your fund will therefore be available to your family until it’s exhausted.
LIFETIME ALLOWANCE CHARGE
The widows pension won’t count towards Zara’s personal LTA.
Uncrystallised funds on your death are tested against your remaining LTA, so anything crystallising above the protected £1.5M will be subject to the LTA charge.
But nominated funds won’t count towards any beneficiary’s personal LTA.
FLEXIBILITY AND TAX
Zara’s widows pension will be taxed at her own income tax rates. She has no control over her income or when she takes it.
While she’s working, she will have her salary and savings income, and so the pension will push more of this into the higher rates of income tax.
Once she has retired, her salary will be replaced by her own pension although, if this is held in a plan that offers flexi-access drawdown, the amount taken can be tailored to meet her needs and minimise her tax.
If you die before 75, your nominated beneficiaries can draw from their inherited share of your fund tax free.
If you die aged 75 or older, they will be taxed on any withdrawals at their own personal rates of income tax. But they can choose when to access the funds, so have some control over the tax they pay.
While it may be tempting for your family to draw out all their share in one go, this would not be rational if they just re-invest it outside the pension wrapper, as they would lose the tax protection a pension scheme gives.
This case study is for general information only and is not intended to be individual advice. You are recommended to seek competent professional advice before taking any action. Tax Planning services and Estate Planning are not regulated by the Financial Conduct Authority. This case study represents our understanding of law and HM Revenue & Customs practice as at 04/10/2016.