Financial planning is a significant chunk of ensuring you enjoy the lifestyle you want in retirement. Your pension will be the source for most of your retirement income, so it's only natural you want to ensure you get the most from it.
If you're on a final salary pension scheme, you might get an offer to transfer out of it. Large numbers of people are offered considerable sums to transfer their final salary pension. At the outset, these offers can seem too good to pass. But is it more of a classic 'too good to be true' situation?
What are final salary pensions?
Final salary pensions work as the name suggests: they pay you a pension based on your final salary at retirement. You get a guaranteed income for the rest of your life. The payment is index-linked to ensure it keeps pace with inflation.
Final salary pensions are a type of defined benefit pension, where your post-retirement benefit is based on your salary at retirement. The other type of defined benefit pension is a career average pension. For these schemes, the average wage across your career is the basis for your post-retirement benefit.
The income you’ll get from final salary pensions is based on:
- The number of years you worked with the employer and have contributed to the pension scheme.
- Your salary at retirement.
- Your pension scheme’s accrual rate, i.e. the proportion of your earnings you’ll receive for each year spent in the scheme.
Each final salary pension scheme has rules to calculate and determine your payout. So it's always worth getting to know the pension plan you're on to get a clear picture of what your income would be.
All final salary pension schemes have a defined retirement age. Early retirement is often possible from age 55, but this might mean giving up some benefits.
Final salary pensions are always set by your employer, as they are workplace pensions. You can’t set up your own final salary pension. If your employer doesn’t offer it as an option, you won’t get it elsewhere.
How do final salary pension transfers work?
If you’re not satisfied with your final salary pension, you could consider transferring it. Transfers are not available to those under an unfunded public sector scheme. If you’re working in the armed forces, the NHS, the police force or a teacher, then your pension might be part of these unfunded schemes. You also cannot transfer a final salary pension once it's in drawdown.
You can't transfer your final salary pension willy-nilly, either. If your pension transfer is £30,000 or more, you must consult a financial advisor before the transfer.
If you take on a transfer, you’ll receive a lump sum of money. These are called cash equivalent transfer values (CETVs). Your final salary pension determines the value of what you’re offered. You can then use the cash sum in two main ways. You can either:
- Transfer it to a personal pension scheme if you’re still saving for retirement.
- Transfer it to a drawdown account, where you can invest some and take some out as regular income as you retire.
Once you've transferred your money out of a final salary pension, you can't invest it back into the scheme.
The lure of final salary pension transfers
Final salary pensions are famous for being generous, and these days are rare in the private sector. The payouts are guaranteed for the rest of your life - you know you'll be getting a good income no matter how long you live.
Maintaining these defined benefit pension schemes isn't cheap, and their numbers are dropping. However, final salary schemes continue to be common in the public sector.
Because these schemes tend to be expensive to maintain, many employers and pension schemes have started offering alternatives. For example, CETVs give you access to a lump sum while forfeiting your right to future payments from the final salary scheme.
There are several potential benefits to transferring your pension - at least before considering what you stand to lose.
Assessing your retirement savings is essential. A vital part of this assessment is the level of flexibility you get. With final salary pensions, there isn't much flexibility. You get a fixed income, and that's it. By converting your final salary pension to an annuity or another pension fund, you get more choice on how you access your money.
You don't have to wait to draw down more significant sums. If you want to spend more during your early retirement years, you can. You can also enjoy flexibility in terms of when you retire and start drawing your pension.
The flexibility can seem beneficial in cases where:
- Your retirement income isn’t reliant on your final salary pension. When you have many other sources of income, the flexibility to invest your pension money can be advantageous.
- Your health issues cause you to believe your life expectancy after retirement is low. One of the only iron-clad reasons for final salary pension transfers are situations where you're not expected to live much beyond your retirement age. Transferring gives you more flexibility to enjoy your pension money early on or provide an inheritance to your loved ones.
The above, however, are rare cases, and most pensioners won't benefit from this flexibility.
Income from your private pension is subject to income tax. However, you can draw some of it tax-free. Many who opt for final salary pension transfers do so to take a more considerable sum of cash tax-free, but the reasons are complicated. In general, you often can’t enjoy the same level of instant tax-free withdrawals with a final salary pension as with other schemes.
You can find out more about pensions and income tax from our guide.
Another major lure for many can be the way final salary pension transfers could impact your inheritance. Since 1997, final salary pensions schemes have been legally bound to provide a pension for widows or dependants. Many schemes will offer a 50% pension to your spouse, but some can provide higher benefits.
With other pensions schemes and funds, your spouse or children receive your pension even when you die. In some cases, your beneficiaries may even inherit your pension free of inheritance tax. The current rules allow your entire pension fund to be inherited tax-free if you die under 75.
The downside of final salary pension transfers
The potential benefits of final salary pension transfers can seem exciting. But there are significant downsides to final salary pension transfers. In this case, the reality isn't as good as it sounds.
You give up pension certainty
A final salary pension gives you certainty. You are guaranteed to receive a certain income for life. If you transfer your pension into cash and invest them in other ways, you have a lot less certainty on how the money will last. You may end up using your money faster than you need. If you spend cautiously, you might not enjoy the full benefit of your retirement earnings. You might end up in a situation where you start running out of money as you’re living longer than you might have thought.
Final salary pension funds also protect you from inflation. You have built-in certainty you aren't losing out too much because of inflation protection. However, if you transfer the money, you have to know how to manage the inflation risk. There are inflation-linked annuities you could turn to; however, they are often less cost-effective. The protection on offer also tends to be lower. Ultimately, you need to manage this inflation risk yourself. If you're not a financial wizard, you might find all this planning much harder.
You need to take more risks
You’re setting yourself to face more investment risks when you transfer your final salary pension. With a final salary pension, your income is guaranteed. Although these pension schemes often invest your money in a range of assets, your earnings aren't tied to the assets' performance.
When you transfer your final salary pension, you need to decide what you do with it. You'll often end up putting a significant portion of it in other pension funds or investments. But investing always comes with a risk; some assets offer lower risks than others. You can reduce these investment risks, but they will still be higher than with your guaranteed final salary pension.
Ultimately, you are placing your retirement prospects in the hands of the financial markets. You could end up investing in low-risk funds, but which may result in you receiving less income. If you opt for higher risk, you could end up earning more or losing a big chunk of your retirement income.
Final salary pension transfers are rarely a good idea
Final salary pension transfers are appealing to many. The low interest rates and inflexibility of how you use your retirement money can make the grass look greener.
But final salary pension transfers are rarely going to be beneficial for you. Financial Conduct Authority (FCA) Guidance argues against final salary pension transfers. The FCA urges financial advisors to start a review from the assumption that a transfer will be unsuitable for a client.
Before you make any hasty decisions, you need to fully understand your financial situation in retirement. Final salary pension transfer can be riskier and reduce your pension income. You could be trading away a regular income. That’s not to say that you couldn’t ever benefit from them.
But if you are approached or offered a final salary pension transfer out of the blue, you need to be careful. The most important thing is to seek advice from a regulated financial advisor. In most cases, this is a mandatory thing, and there's a good reason for it. Final salary pension transfers are rarely going to leave you better off. You always need to assess your individual situation carefully. Of course, there are rare occasions where you might be better off. But for most, personal circumstances won't make final salary pension transfers advantageous.