People in, or approaching, retirement with a ‘gold-plated’ defined benefit (DB) pension scheme should strongly consider their options before transferring it to a lump sum, according to Brewin Dolphin.
DB schemes are a form of final salary pension, whereby savers are given a guaranteed income for life based on their final salary or average salary.
However, more people are choosing to transfer out, preferring to be given a lump sum rather than the income, according to data from the Office for National Statistics. In 2019, the latest report available, £32bn was pulled from these schemes in total.
But people intending to cash in their defined benefit pension now face a “perfect storm” of economic and market turmoil that will leave them short-changed, according to Brewin.
Savers are typically given a fixed amount to transfer based on the amount of income they can generate from these risk-free assets – usually gilts.
This year, gilt yields have rocketed as central banks raised rates to combat rampant inflation, as the below chart shows. This means that retirees are being offered less as a result.
Gilt yields, interest rates and inflation since 2000
Source: Brewin Dolphin
As an example, someone with a defined benefit pension offering an annual income of £30,000 per year might be offered a lump sum of £1m if interest rates are at 3%. However, if these rise to 4%, they may be given £750,000.
Recently, a £1.3m lump sum offered to an RBC Brewin Dolphin client by their former employer was lowered by £850,000 in just three weeks.
Daniel Hough, financial planner at RBC Brewin Dolphin, said that the current economic conditions had created a “perfect storm” for those looking to transfer their DB pension.
“It will mean a lot more companies may make seemingly generous offers to their former employees to get their pension liabilities off their books – a large lump sum payment now may seem tempting, but it may prove a poor long-term decision,” he said.
Rob Burgeman, senior investment manager at the firm, agreed, noting that the low interest rates of the past decade have been an anomaly compared with history and are unlikely to be seen again in the near future.
He argued that inflation will trend towards the 2%-4% range, rather than the 0%-2% that followed in the decade after the 2008 financial crisis, with interest rates likely to be within the same band.
“The shorter dated area of the gilts market looks to be steadying, but the longer part – particularly 20-to-30-year bonds – is still going up,” he said.
“It is usually longer-dated gilts that determine government borrowing costs and, with that, defined benefit transfer rates. Anyone considering transferring out of a DB pension could find themselves with difficult long-term choices to recreate the pension they would have been entitled to.”