Defined Benefit Pensions- Trust the Guarantee or Take the transfer value?
**This article does not relate to public sector pensions. Public sector pensions are financed and back by the state**
Firstly, lets smash a common myth surrounding defined benefit pensions. Many people think that defined benefit pensions are guaranteed pensions , are as good “money in the bank” and are “risk free”.
Sounds great, doesn’t it?, Yet this is simply not true.
In theory, keeping your pension in a defined benefit scheme means you’ll receive a fixed income in retirement, but as with many things in life, there are risks you should always be aware of:
Risks with Defined Benefit Pensions:
1.The strength of the guarantee behind the pension income promised to you from your defined benefit pension depends on the scheme’s solvency and the employer’s commitment.
2.If the scheme has a deficit, your benefits might be affected, and you may get less pension income than originally promised.
3.Your pension could be backed by a Sovereign Annuity (Government Bonds), subjecting it to market risks.
4.There’s a chance of a reduced pension on scheme restructuring or wind-up.
5.If the funding and assets of your defined benefit pension scheme is not sufficient to satisfy the minimum funding standard, the pension trustees may apply to the Pensions Authority of Ireland for a ‘section 50 order’. In this scenario you may receive less of pension that you have been promised.
6.Even when you reach retirement and are in receipt of your defined benefit pension, there is still a risk that the pension income could be reduced.
A famous Irish case that comes to mind is Waterford Crystal’s Defined Benefit Scheme. “Waterford Crystal was placed in receivership in January 2009 and the company’s pension schemes were wound up two months later with a deficit of some €110 million”. “Given the funding levels in the pension schemes workers were offered payments representing between 18 per cent and 28 per cent of their entitlements”. However, this case was later taken to the European courts:
Court rules in favour of Waterford Crystal workers – Link
The point I am making is, the so-called Guarantee that comes with defined benefit pensions is only as good as the financial strength of the pension scheme and employer behind the guarantee.
On the other hand, providing the scheme is in good financial shape and it has the backing of a financially sound employer, there are clear advantages to a defined benefit pension:
Benefits of a well-funded Defined Pension Plan:
1.Your pension is normally adjusted for inflation until normal retirement age (NRA).
2.You do not have to worry about your pension income lasting your lifetime as the employer bears investment and longevity risks.
3.In the event of your death before retirement, your spouse could be entitled to a lump sum or a spousal pension. What your spouse receives will depend on the scheme rules.
4.You might receive discretionary pension increases in retirement.
4.Guaranteed Spousal Pension, normally 50% of your original pension may be available to your spouse in the event of your death.
5.Your promised retirement income is known to you in advance allowing you to plan your retirement.
Taking a Transfer Value to a Defined Contribution Arrangement
An alternative to staying in a defined benefit scheme is to take a transfer value as lump sum and invest it into a defined contribution pension, usually a personal retirement bond in your name or into your current employers defined contribution pension scheme.
What is a transfer value?
A transfer value is a lump sum that is offered to defined benefit pension scheme members in return for them giving up their right to an annual income from the define benefit scheme at retirement.
What is an enhanced transfer value?
This is usually a transfer value offered which has enhanced terms on offer, usually a higher transfer value than what would normally be offered.
Now before you go running for the cash, there are pros and cons to this option too:
Potential Benefits of taking a transfer value:
1.Access to retirement benefits earlier, normally from age 50. This gives you more flexibility around what age you retire or access your pension income.
2.If your Transfer value invested performs well, there is the possibility of a higher lump sum at retirement and better retirement benefits compared to the original defined benefit scheme.
3.Option for an Approved Retirement Fund (ARF). An Approved Retirement Fund is where your pension funds will be held in retirement and this fund will be in your name. In the event of your death, the full value of the ARF passes to your Spouse. This could work out to provide more consistent retirement income compared to the 50% spousal pension that commonly comes with many defined benefit schemes.
4.The Approved retirement fund option gives you the option of taking 25% of your pension fund tax free, this may work out to be a higher tax-free lump sum that what is offer under the defined benefit pension.
5.If the defined benefit pension trustees want to reduce their long-term liabilities within the scheme, they may offer member enhanced transfer value offers. At times these enhanced transfer offers can be an attractive option and great value for members.
6.By taking a transfer value it gives individuals the ability to manage their pension investments personally.
7.If the defined benefit scheme is experiencing solvency issues and these issues are not addressed, you could be offered a lower transfer value or reduced pension income in the future due to scheme conditions worsening.
Potential disadvantages of taking a transfer value:
1.Like all defined contribution pensions, your transfer value will be invested and the benefits you receive will depend on investment performance, this can create some uncertainty regarding future retirement income.
2.Transfer values change and there is always the possibility of a higher transfer value in the future compared to the offer available now.
3.You will be taking be taking over responsibility for the investment performance of your pension. For some this will not be an issue for others it will, it all depends on your personality and ability to handle market volatility.
4.Depending on the defined Benefit pension benefits offered to you, you may have difficulty in replicating the DB pension benefit with your transfer value invested.
Making a Decision:
There is no one size fits all answer here, for some the transfer value on offer will be a no brainer, for others the pension income promised from the defined benefit pension will give them peace of mind.
You should seek expert financial advice and with your advisor take into consideration some of the following:
1.Scheme solvency- are there currently enough assets in the pension scheme to cover pension income promises made to members?
2.Employer financial strength and their commitment to funding defined benefit pension scheme.
3. Your health status, this could be a major factor that influence your final decision.
4. Your personal investment risk tolerance- are you a low, medium, high risk investor??
5. Assess all your retirement income sources, have you more than one pension or assets for retirement?
The above list is not exhaustive, but they are some of the key areas that you should consider. Remember delaying decisions also carries risks, for example, the funding position of your defined benefit pension could worsen over time.
Finally….
The decision between keeping your defined benefit pension or transferring it to a defined contribution pension plan is complex. Seek advice from financial experts to make an informed choice aligned with your retirement and ensure you have no regrets in the future.
Remember, your pension is a crucial part of your financial future, so choose wisely.
Finally, If you have any questions or if you would like to help with your pension, you can reach me personally on 01 582 3523 or email me at Aidan@financiallife.ie
Thanks for reading
Aidan
Disclaimer: The information provided in this blog post is for informational purposes only and should not be considered professional advice. It is advisable to seek expert financial advice for personalized guidance regarding life insurance.
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