Defined benefit (DB) pension schemes may be vanishingly rare for today’s pension savers, but there is still a generation retiring today with a tricky decision to make.
Low interest-rates have left the income available from DB schemes highly prized, boosting transfer values to record highs.
The most fortunate of today’s retirees are being offered up to fifty times the income they would have received in retirement as a lump sum. For many, it presents a difficult dilemma – take the money and hope that they can replicate the income elsewhere? Or stick with a guaranteed income for life?
The market for pension transfers has ballooned. A survey of more than 800 financial advisers for insurance group Royal London in June found growth of more than 50% in the volume of transfers-out of final salary pensions over the previous 12 months, with the most common transfer value lying in the £250,000 to £500,000 range, some way ahead of the average house price.
This has proved attractive for many retirees – advisers report increasing numbers seeking transfers, plus an increasing number of ‘insistent’ clients, for whom the sums involved are sufficiently large that they are willing to ignore financial advice and transfer anyway.
Large transfer values are one lure, but there are others: flexibility is also important for many retirees. In particular, the ability to take income through retirement, or more when it is needed, while leaving it to accumulate when it isn’t, has a seductive logic for many retirees. They can take large amounts in their early ‘holidaying’ years immediately after retirement, for example, or later on when they may need care.
There are also important inheritance tax (IHT) considerations. The IHT treatment for drawdown is more attractive, in general, than it is for annuities. The punitive 55% pensions ‘death tax’ was abolished in 2015, with the income or capital from a pension pot paid out tax-free to beneficiaries if you die before 75, or at their marginal rate if you die after 75.
With drawdown, the calculation is straightforward – the beneficiaries receive what is left in the pot. With annuities, they will only receive something if the annuity has specific provision under a joint annuity, a guaranteed period or some capital protection built in.
However, there are real drawbacks to transferring. Retirees are giving up a guaranteed income for life and may not realise the implications of a transfer.
Certainly, in the current low interest-rate environment, it is very difficult – if not impossible – to replicate exactly the stable income provided by an annuity. Drawdown income will often incorporate equity risk, which may offer the potential for higher capital growth, but returns are less predictable day to day.
Equally, many people are prone to underestimating the amount of time they spend in retirement. While many may be attracted by a chunky transfer believing that they may only have 10 years to live, for most people living too long is a far greater problem than not living long enough.
There have also been examples of retirees enacting pension transfers and then leaving the money in cash. This is the worst of all possible worlds: leaving the money neither generating an income, nor protected against inflation.
This situation has, naturally, attracted the attention of the regulator.
The Financial Conduct Authority launched an investigation into the advice given on pension transfers early in 2017 and found that some of the advice investors were receiving at retirement fell short of expectations.
Most of these were administrative rather than fraudulent. For example, in some cases, there was a lack of information sharing between the adviser and a specialist transfer firm.
This resulted in unsuitable advice where the specialist firm did not have enough information about the client’s objectives, needs, and personal circumstances. Of the cases examined, 17% were unsuitable, and in 36% of cases, it was not clear whether the recommendation was suitable.
This is a sensitive issue for advisers who have fallen foul of the regulator previously on pension transfers. Most are extremely wary as a result. Yet everyone with a pot of £30,000 or more has to take advice before transferring.
There is a danger that the pendulum swings the other way, where those who would benefit from a transfer are advised against it because the adviser is concerned about his own business risk.
Once in a lifetime choice
In my experience, the right decision is unique to every person. A major issue with transfers has been what happens to the pension afterwards.
It needs to be properly invested to create a sustainable income unless investors have money elsewhere. This is where self-invested personal pensions (SIPP) have become so popular. Not only do they offer control and clarity to the pensioner as to where and how their pension pot is invested, but the costs for administration have come right down in recent years.
SIPPs can often be managed alongside the pensioner’s ordinary and ISA portfolios and therefore the tax efficiencies for contributions and withdrawals managed the more easily. With SIPPs now becoming such valuable IHT planning tools, it is sometimes the case that drawing down on an ISA portfolio makes more sense while preserving the pension pot for IHT-efficient inter-generational transfers.
But transfers require careful handling as not all pensions are the same. Equally, the original pension scheme itself is vitally important: what extras does it offer? Does it have spouse provision, for example? It is also necessary to consider whether the retiree is in good health. If not, would an impaired annuity be a better option than drawdown? What are the family circumstances and how important is leaving a legacy?
Equally important will be a retiree’s attitude to risk. We have lived through a benign period for drawdown with a lengthy bull market in equities and bonds. However, the outlook for growth is potentially more muted over the next phase; investors not only need to ensure that a decumulation plan can ride out difficult conditions but also that they can withstand some variability in their income.
Retirement freedoms are bedding down; at the moment, there is still a tendency to see drawdown versus annuities as a binary decision.
With time, this is likely to shift, with each recognised for its own merits. As such, the decision may not be ‘to-transfer-or-not-to-transfer’ but a more nuanced appreciation of the role both annuities and drawdown can play in a retirement plan.
James Johnsen is head of business development at Church House Investment Management