Defined benefit pension schemes have become unaffordable for most employers due to escalating liabilities. Many have closed to new entrants and new accruals, with others wound up.
It’s why many deferred members of defined benefit schemes receive offers of enhanced transfer values (ETVs) from former employers anxious to wind schemes up.
But what’s the best option – to stick and wait to receive your pension entitlement in retirement? Or twist and invest it in a defined contribution arrangement that offers more flexibility in terms of investment and retirement options?
It’s a decision likely to face the hundreds of thousands of people who have legacy defined benefit (DB) pensions.
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Anyone offered an ETV to get them out of their defined benefit scheme has a lot to think about says Trevor Booth, head of individual advice at retirement benefits consulting firm Mercer.
“One is the value for money of the ETV. The other is, does it offer you additional options that you didn’t have under the defined benefit pension?” he explains.
In terms of value for money, the question is whether you think you could replicate the DB income from the enhanced transfer value?
The DB scheme aims to provide a pension for the rest of your life post-retirement, and possibly an income for your spouse after you die. Do you think you can grow the ETV and use it in retirement to provide a similar level of income?
Figuring it out is challenging but happily you’re unlikely to make it alone.
“Typically, where an individual is offered an enhanced transfer value, they’ll be offered access to financial advice as part of it,” says Booth.
One of the first things your financial adviser will look at is the value for money aspect.
“It’s not a straightforward thing to do because you’re taking a value – an enhanced transfer value – right now and trying to project it forward, making assumptions around what the future investment return will be, to estimate what level of income you’d be able to provide for that person in retirement,” he explains.
“We’d be looking to see if can you replicate your defined benefits. If you can, then you have pretty good value for money on your enhanced transfer value.”
Part of the process is understanding how the individual is likely to invest their ETV.
If they put it into a cash fund, for example, the investment return will be negligible, meaning they are unlikely to replicate the level of income that they would have from the DB pension.
“Typically people need to be able to take a moderate level of investment risk with their fund to make it good value to take an enhanced transfer value,” says Booth.
There are other considerations too.
“You have to ask what other advantages it gives you. Your defined benefit pension is very rigid. It’s a set of rules that says you will get paid a defined amount, at a defined time. The ETV gives you options in terms of when you access your pension. Once you’re over 50 and have left your employment, you could choose to access your ETV to draw down some benefits. With a defined benefit plan, you may not be able to do that,” he explains.
For somebody who needs access to their funds soon, say to put kids through school, flexibility could trump the value of the money.
“As part of our process we ask people to rank their priorities for the ETV. Is it about maximising the value of the money, or is it about creating other opportunities?” he says.
The fact that the ETV element of the pension can be inherited by your children, in a way that defined benefit schemes can’t, might be a factor. For those with a life-threatening illness, ready access to the money might be a priority.
Finally, don’t turn down the ETV just because you think that, simply by offering it, your old employer is trying to diddle you, it’s not.
It’s because pension liabilities sit on their financial statements and, as interest rates change, their values can change dramatically, often with unintended consequences for the business. “By offering enhanced transfer values, they give themselves a little bit more certainty. It’s about risk control,” says Booth.
