DB or DC? – achieving the right client outcome
December 13th, 2016
Demand for DB transfer advice is soaring on the back of high transfer values and pensions freedoms. Most will be best served by staying with DB, but there will be others who could achieve a better outcome by taking control of their own savings and moving to a SIPP.
Who is a transfer right for?
This essentially comes down to 4 key considerations:
- Client needs and aspirations – Will the client’s needs be better met after a transfer than before?
- Income sustainability – What is the client’s capacity for loss? Would a transfer mean they risk running out of money in retirement?
- Value – Does the TV represent ‘good value’ for this client?
- Client understanding – Do they properly appreciate the implications of moving from a guaranteed income for life to a flexible pot subject to market fluctuations? Are they equipped to manage it (intellectually and emotionally)?
The overwhelming majority of people who have a DB pension are best advised to stick with it. A guaranteed retirement income may provide peace of mind that the bills will be paid in old age. Giving up this guaranteed, inflation-proofed income for life could be a risk too far. While high TVs may be very seductive, it’s important to remind clients that it has to last throughout their retirement. Most simply can’t take on the downside risk of moving to DC.
But for wealthier clients, worries about paying their bills or running out of money won’t be an issue. A DB income for life may simply mean surplus income and unnecessary tax. A transfer to a modern, flexible DC pension may be a better fit for their needs. For example, they may be planning a more active lifestyle in the early years of retirement, spending more money early and less when they’re older. The ability to take income and tax free cash from a SIPP at the levels they need, when they need it, may give a more tax efficient income and a larger legacy for loved ones.
At the extreme, there will be those who don’t need their pension to support themselves in retirement at all. Instead, they may see a move to a DC pension as a way to preserve accumulated pension wealth and cascade it down to their family tax efficiently. It may provide a larger death benefit and opens up a much wider range of potential beneficiaries. And because a SIPP offers protection from IHT, by spending their non-pension savings and investments to support themselves in retirement, they are potentially reducing their IHT bill.
There are also reasons why a transfer may provide better ‘value’ because of an individual’s particular circumstances. These include:
- Ill-health: Clients in ill health, with a shortened life expectancy, may get poor value from a DB pension, because it may not be paid for very long. A transfer to DC may give them a higher income for their lifetime, and death benefits may also be superior.
- Single status: For clients with no spouse or civil partner, a widow(er)’s pension from a DB scheme may be irrelevant to them. But the notional cost to the scheme of providing this benefit will be reflected in the transfer value.
- Concerns about the security of the DB pension: Clients with a promised DB pension significantly above the Pension Protection Fund cap (currently £33,678) could face a large loss of value should the sponsoring employer become insolvent. Transferring out to a SIPP may give better value and more control over their futures.
Partial transfers – the best of both?
There will be some clients where a bit of each could provide the best outcome. By only transferring part of the DB value to a SIPP, and retaining a smaller DB pension, a client may benefit from the income flexibility and estate planning goals that they desire plus the security their remaining guaranteed DB pension income provides.
Not every DB scheme currently offers the option of a partial transfer. But if this ‘best of both’ option is the best fit for your client’s needs, ask the question. Growing numbers of schemes are seeing this as a win/win option that gives the member what they want and helps reduce liabilities efficiently.
What is driving the high DB transfer values?
There are several forces at work here, but the bulk of the increases in recent years have been driven by:
- Falling gilt yields;
- Lower expected investment returns (reflecting a reduced risk appetite); and
- Improved life expectancy.
Low gilt yields have had by far the greatest impact in recent times. And it’s likely that changes in gilt yields will continue to have the single biggest impact on DB transfer values going forward.
The economic and political turmoil of recent times have increased demand for gilts. But this rush for relative security has driven yields down. As DB schemes rely on gilts to match liabilities, the cost of providing the promised benefits has gone up – and transfer values have followed.
Allied to this, as schemes have matured and/or closed during a period of volatile markets, scheme trustees have been taking less investment risk, reducing equity exposure in favour of gilts and fixed interest stocks – with the lower expected returns creating further upward pressure on TVs.
Gilt yields can, of course, fluctuate based upon prevailing economic conditions.
Increasing life expectancy, on the other hand, is more permanent. Scheme trustees now expect to pay pensions for longer, which is reflected in higher transfer values.
Finally, employers may be motivated to encourage transfers where a scheme deficit is dragging down net asset values on their balance sheet. This is because transfer values are normally smaller than the ‘book value’ of the benefits sitting on the employer’s balance sheet, so transfers can be the cheapest way of reducing this liability.
Technical considerations – ensure there are no surprises ahead
If a transfer looks right for a particular client, there are some technical considerations to be aware of to ensure there are no surprises once given the go ahead.
- Transitional protection: Where a client has protections associated with their pension savings (such as enhanced or fixed protection, scheme specific tax free cash protection, or early retirement age) care should be taken to maintain these protections following the transfer. Areas to think about include ‘block’ transfers, the ‘permitted transfer’ rules and the ‘appropriate limit’.
- Lifetime allowance: With DB transfer values often more than 20 times the DB pension given up, a move to DC may create a greater excess over the LTA. Clients may perceive a potentially higher LTA charge as a barrier to transferring. It’s important to refocus the client on what gives the best outcome for them, not the tax. And remind them that they can control when they crystallise any excess DC pot and how much they take, allowing them to defer the LTA charge while still having control over their pension savings.
- Inheritance tax: If a client in poor health transfers, and dies within 2 years, HMRC may consider there to be a transfer of value for IHT. This is not necessarily a barrier to transferring if the net benefit taking account of an IHT charge is still better than the death benefit available from the original DB scheme.
Most clients with defined benefits will be best advised to keep them. Having a sustainable income in retirement has to be the number one priority.
But not everyone needs a guaranteed income in retirement to feel financially secure. Some will have other savings and assets to provide that security, allowing them to withstand the ups and downs of investment markets. The flexibility of ‘anytime access’ from a SIPP may have more appeal, and prove better suited to their income needs and plans for passing wealth on to their loved ones.