When I was a young stockbroker, I was a member of my bank’s defined benefit (DB) pension scheme. I left that bank in my mid-twenties and they sent me a cheque to cover the value of my entitlement until then. It was, as I remember it, for something in the region of £10,000. I can’t tell you how thrilled I was.
And in retrospect, what an idiot I was not to send the money back and demand to stay in the scheme. But I knew nothing then of the difference between DB pensions and defined contribution (DC) pensions.
I do now. A DB scheme is a company or public sector deal which provides you with a set and inflation-linked annual income from the point of retirement, for life. A DC scheme, the type most of us outside the public sector now have, just involves the provision of a tax-efficient wrapper into which we, and often our employers, put cash. The level of luxury we get in retirement is based on how much money goes in and how well the investments we choose perform.
Look at those descriptions and you will immediately see my idiocy. Who would rationally choose to give up long-term income security for a short-term (and small) pile of cash? No one.
But here’s the thing. If I were about to retire today with a DB scheme I might be starting to think about giving it up, or rather transferring out of it into a DC scheme for my retirement. That’s because however brilliant income security is, the recent pension reforms mean that DC pensions have two things to offer that DBs never will: flexibility and inheritability.
DB pensions payments die with you (or your spouse — it depends on the scheme). Kick the bucket a few years after you retire and a lifetime of salary sacrifice was in vain. But the new rules on DC pension pots mean that, subject to your marginal rate of income tax, not only can you draw as little or as much cash as you like down from your pension pot whenever you like, you can also leave whatever you don’t want or need from your pile of cash to your kids free of inheritance tax.
Tempting, isn’t it? It gets better. Very low interest rates mean that transferring out is rather more lucrative than it was, because low rates make the present value of future payments higher. Consultants Hymans Robertson estimate that for each £1 of annual pension you give up, you’ll get about £25 of capital, although transfer values will be different for all schemes. So if you are expecting a £10,000 a year pension, you could transfer something in the region of £250,000 into a DC pension pot instead and do with it as you like.
You can see how that might look pretty good to those in very poor health or those obsessed with getting their kids on the housing ladder and willing to take an initial tax hit to do so. It will also appeal to the wealthy, who tend to value inheritability over income security. All this has not passed unnoticed: according to research by Hargreaves Lansdown, a third of those in private sector DB pensions (around 1.6m people in total; public sector schemes cannot transfer out in this way) are either planning to transfer to a DC pension or actively considering it, for exactly the reasons outlined above.
This brings problems of its own. For decades, politicians have worried about what happens if you let people swap something good for something easily lost. My archive of the now-defunct Statist magazine shows the pensions industry ridden with the same angst back in the 1960s. The edition of April 3 1964 was largely fixated on the odds of a June election and on finding ways to force manufacturing to grow but still found space for a couple of pages on the horrors of employees cashing in pensions for lump sums. Back then one in six companies allowed workers to take their money out and there was pressure for a programme to try to educate employees “leaving service . . . that it is better to accept a paid up pension” than anything else.
It’s the same today. David Woodhouse of advisers Chase de Vere warns that those “seduced by the prospect of flexibility” won’t quite understand what they are giving up in terms of income security and peace of mind. Lump sums can disappear fast in the hands of inexperienced investors and of course the second a pension leaves the safety of its DB prison to be “flexible” it becomes a natural target for the amoral salesmen determined to separate the over-55s from their cash.
But the risk that should worry you most is political risk. When you have a DB contract you have a deal, and the company with which you have that deal has to honour it. If the company fails, there is a partial safety net in the shape of the Pension Protection Fund.
Holders of DC contributions have no such security. They have no deal with the stock and bond markets. They have no deal with their employers, whose obligations end with setting up a scheme and paying some money into it. And crucially they have no deal with the government. All pension money remains, forever and always, subject to the reforming zeal of whatever ideologues happen to be in power.
The Tories want to help rid companies of the long-term liabilities of DB pensions and they believe in individuals taking personal financial responsibility and in allowing wealth to cascade down the generations. So they have introduced flexibility and inheritability into pensions. Labour does not. If the Labour party forms or dominates the next government, is it reasonable to think that they will allow this new system, which permits the rich to treat pensions as long-term untaxed family trusts, to remain in place?
I can’t see it myself. And that, I think, is why for now not many of us should do more than daydream about giving up DBs. It is also why any competent IFA you visit for advice on the matter will tell you to take lifetime income security over a bet on multigenerational tax avoidance. He or she will remember past mis-selling scandals connected with transfers and will also know that financial security is too hard to come by to give up lightly.