What is a defined benefit/final salary scheme? It used to be considered the most generous and secure type of pension arrangement, often referred to as a gold plated pension. The generosity of these schemes has resulted in most of them being forced to close, restrict access or reduce benefits because they are so expensive for the employer to provide and operate.
Recent high-profile cases of doomed pension schemes, such as the BHS collapse, and Tata steel have highlighted concerns over the future of workplace pensions in the UK.
So what is is an underfunded pension plan? Quite simply it is a retirement plan that has more liabilities than it does assets. In other words, the money needed to cover current and future retirements is not readily available. Hence, there is no assurance that future retirees will receive the pensions they were promised or that current retirees will continue to get their previously established distribution amount.
The more underfunded a pension plan is, the more likely it's going to run out of money and the more likely retirees will receive less than they expect or worse still will receive nothing and instead receive a lesser pension from the PPF.
There are several reasons for a plan being underfunded. Such as how the pension fund is managed, the fund may not be diversified enough to weather downturns in the stock market. Or the contributions may not be enough to cover everyone in the plan. People are also living much longer, making guaranteed pensions more and more expensive to provide.
Deficits in these schemes remain at sky-high levels despite the fact that employers have dug deep into their corporate pockets, allocating £120 billion over the past decade in a bid to reduce deficits. A growing number of employers that run "final salary" pension schemes are coming under extreme pressure to meet their obligations,
If a pension scheme collapses and the employer becomes insolvent the UK Pension Protection Fund (PPF) may honor the benefits, so long as the PPF can itself take on the burden. The PPF is not Government backed and is a levy on other similar pension schemes. It is important to note that even if the PPF steps in that only 90% of your benefit will be protected with a cap at age 65 from 1 April 2017 of £38,505.61 (this equates to £34,655.05 when the 90 per cent level is applied) per year. Therefore people with larger pensions are more likely to be impacted by this.
In light of the increasing deficits more and more people are considering their options and whether it may be better for them to exit a scheme completely.
The attractions of transfers have also been boosted by rule changes allowing cash to be taken from a pension from age 55 and residual funds to be bequeathed on death, not to mention the staggering increase in transfer values.
Transfer values have risen so dramatically in recent years because yields from bonds – in which final salary pensions are mainly invested – have fallen to record lows. Low bond yields increase the cost to pension schemes, as they need larger funds to produce the same income, which is why they are keen to reduce their liabilities and get pension savers with financial salary pensions off their books.
Of course transferring out of a DB scheme should always be considered on a case-by-case basis, as each scheme will have its own parameters.
As a starting point, there are a number of circumstances which warrant the consideration and review of your UK DB scheme:
You are concerned about the funding levels of the schemePassing on as much wealth to your spouse and beneficiaries is a priority for you;You wish to mitigate future income tax liability as much as possible;You are likely to be in excess of the lifetime allowance by the time you retire ( At time of writing this stands at GBP1million);You are concerned about future amendments, and possible reductions in benefits to your final salary scheme;You wish to pass on a lump sum death benefit to a beneficiary of your choosing.
What are the alternatives?
A Self-Invested Personal Pension (SIPP) is the name given to the type of personal pension scheme, which allows individuals to make their own investment decisions from the full range of investments approved by HMRC. Traditional personal pensions limit your investment choice to a shorter list of funds normally run by the pension company's own fund managers. With a SIPP you can invest almost anywhere you like and choose your own investments. The HMRC rules allow for a greater range of investments to be held than Personal Pension Plans, notably equities and property. There are however some limits and you cannot hold assets such as fine wine, art or residential property within a SIPP.
For many individuals who have a number of frozen UK pensions (whether DB or DC schemes) this is a great way of taking control of them and allowing for consolidation of your funds.
Unlike most DB schemes you can access your SIPP at the age of 55 and a SIPP will still qualify for your 25% tax- free lump sum. You can then decide whether to take the rest as an income or take advantage of the new pension freedoms that came into effect in April 2015, which will now allow you to take as much of your pension as you wish.
A Qualifying Recognised Overseas Pension Scheme, or a QROPS, is an overseas pension scheme that meets certain requirements set by HMRC. The QROPS program was launched on 6 April 2006 as a direct result of EU human rights legislation with regards to freedom of capital movement.
QROPS are increasingly popular with British Expats due to currency and investment flexibility, the tax advantages they offer when drawing pension benefits and their ability to be transferred to beneficiaries of choice in the event of death.
Pension funds left in the UK are taxed on income at up to 45% and taxed on death after 75 years old at up to 45%. Transferring a UK pension fund into a QROPS can reduce taxation and in some cases avoid UK taxation as long as the pensioner remains tax resident outside the UK.
A QROPS can be appropriate for UK citizens who have left the UK to emigrate permanently and intend to retire abroad having built up a UK pension fund. Alternatively, a person who is born outside the UK having built up benefits in an HMRC-approved UK pension scheme can move their pension offshore if they want to retire outside the UK. An individual who is also likely to exceed the lifetime allowance would benefit from a transfer into a QROPS.
The income payable from a final salary pension is fully taxable as income and is therefore taxable at a member’s highest marginal rate of between 0-45%. This means that the tax payable can be quite severe. A QROPS has the ability to turn the income withdrawn on and off each year. So individuals may be shrewd and protect their pension against the tax-man by maximizing what they draw when in preferable tax jurisdictions. The new ‘Flexi-access’ rule enables individuals to access their pensions in their entirety or through phased lump sums if they wish.
A final salary scheme will often have quite punitive early retirement penalties for those who wish to draw their pension prior to the ‘Normal Retirement Age’ set under the scheme. Typically a scheme may impose a penalty, known as an actuarial reduction, of 0.5% per month. This means if you retire 12 months early the penalty is a 6% reduction in your annual pension income. If you retire 5 years early the penalty increases to 30% of your annual pension.
A word of warning though. As of April 2017 there is a new tax charge on transfers for some QROPS. HM Revenue & Customs (HMRC) has announced that Qualifying Recognised Overseas Pension Schemes (QROPS) transfers for individuals not in the European Economic Area (EAA) will be hit with a 25% tax charge.
This measure ensures that transfers to QROPS will be taxable unless, from the point of transfer, both the individual and the pension savings are in the same country, both are within the European Economic Area (EEA) or the QROPS is provided by the individual’s employer. A financial adviser will best placed to advice you on this area.
What’s right for you?
Defined Benefit schemes will differ from one scheme to the next and each pension needs to be considered on a case-by-case basis. Understanding the scheme parameters, alongside your objectives, coupled with a thorough analysis of the schemes funding level, will allow you to be able to make an informed decision on the right course of action for you and your nest egg.