Jayne Gibson is a professional financial planner, a pension transfer specialist and the Managing Director of Insight.Out Financial. Below, Jayne speaks to Finance Monthly about defined benefit schemes and the challenges they can come with them, as well as the one thing she would change about them if she could.
Tell us about Insight.Out Financial and your professional career?
We are a friendly and approachable company with a wealth of expertise in pension transfers, personal & corporate financial consultancy. We make our experience and knowledge very accessible to our clients with our empathetic approach, but most importantly – our charges are transparent, fair and reasonable.
I started the company in August 2015 with the aim of building a business that is customer-focused and provides exception standards of service and advice, with professional ethics at the core of our proposition. We are based in Belfast, Northern Ireland, however we have a UK-wide clientele, and regularly visit all regions in Britain.
I have been a Pension Transfer Specialist since 1998, and have extensive experience in advising on occupational pension schemes, including Defined Benefit, Defined Contribution, as well as more specialist pensions for small business owners.
I am one of the first Chartered Financial Planners in the UK and am also a Fellow of the Personal Finance Society since January 2006, as well as a Chartered Fellow of Chartered Institute of Securities and Investments since 2012. I have continued with my studies, being awarded a Masters in Financial Planning & Business Management in 2012. I am currently working towards a PhD, with a focus on building consumer confidence in the financial planning profession.
What attracted you to the defined benefit pension schemes field?
I have been advising on Pension Transfers for more than 20 years. When I first started, there were very few advisers qualified to advise on pension transfers and a lack of knowledge and understanding of the value of the benefits offered and the impact for members of occupational schemes. The main reason for this was the highly complex legislation in place at the time, which was different depending on when a member joined and left a scheme. Pension simplification in 2006 did bring the personal pension and occupational pension regimes in closer alignment, and over the next 10 years, successive legislative changes, culminating in the pension freedoms legislation in 2016 have meant that more and more people need advice.
The advice for many of my clients with defined benefit schemes is life-changing. It is the biggest financial decision they will ever have to make, and will have the biggest impact on their, and their family’s future lifestyle. Changing demographics mean that the traditional “one size fits all” approach for most defined benefit schemes is less and less relevant. More and more people are looking for a different solution and wanting to shape their own personal retirement.
How do defined benefit pension schemes work?
Defined benefit schemes, often referred to as ‘Gold Plated Pensions’ are offered by companies for the benefit of their employees. Traditional style schemes provide a fraction of a member’s salary at retirement for each year they have been in service. For example a 60th scheme would provide 1/60th of a member’s final salary, multiplied by the number of years they had worked for the business:
John has worked for his employer for 27 years and is due to retire at the age of 65 with a final salary of £26,000. His pension income is calculated as 27/60ths x £26,000 = £11,700. The pension of £11,700 is payable from John’s 65th birthday and will increase in payment in line with inflation. It is guaranteed to be paid for the rest of John’s lifetime.
At retirement, most schemes will offer an option to take a cash free lump sum. This can be paid as a lump sum in addition to the pension, or by commutation where part of the income is given up in return for a lump sum. The maximum lump sum available is calculated using HRMC formula of (20 x pension) @ 25%, or another method set down in the scheme rules. If an alternative method is used it cannot exceed the HMRC maximum amount. A commutation rate is then applied to the lump sum to calculate the amount of pension that is given up in exchange for the lump sum required. The scheme actuary will set the commutation rate and this can vary greatly from scheme to scheme. Most public sector schemes use a standard 12:1 rate, however private sector schemes have more flexibility and may choose a rate which more closely reflects the cost of the pension given up.
John has an option to take a cash lump sum by giving up some of his pension. The maximum lump sum he can take is calculated at (£11,700 x 20) @ 25% = £58,500. If he wishes to take the full lump sum, he will have to give up a proportion of his pension. This is calculated using a commutation rate of 12:1. His reduced pension is calculated as follows, £58,500/12 = £4875, £11,700 – £4875 = £6,825 pa.
Many schemes will also provide death benefits for a surviving spouse or in some cases, other financial dependent. This will generally be in the form of a spouse or dependent’s pension, calculated as a percentage of the member’s pension. There are many variations to the formulas used by schemes to calculate these benefits and the eligibility criteria applied by each scheme when assessing a survivor’s entitlement to benefits, it is essential for members to fully understand these, especially where their circumstances are not straight forward. Some schemes will only pay death benefits to a legal spouse, where others have a more generous approach and will consider a life partner, where financial interdependency can be established. It is also important to understand that spouse benefits are not a contractual entitlement and are paid at the discretion of the trustees. Spouse benefits can be reduced and even stopped in some circumstances, e.g. where the spouse remarries or is even co-habiting.
For those in same sex marriages, and civil partnerships, it is especially important to understand the scheme’s eligibility criteria. Under current legislation, there is no compulsion on schemes to change their scheme rules to accommodate changes in legislation. Where rules have been amended, in some cases this will only date back to the date the relevant legislation came into force.
Most schemes will also guarantee to pay the member’s pension for a minimum period of time, generally 5 years but could be as much as 10 years. This in effect means that the member’s full pension will be payable for at least the period of the guarantee period. Any outstanding payments are paid as a lump sum and any spouse pension will commence in payment.
John retired at the age of 65 and unfortunately passed away after two years. His nominated beneficiaries will receive a lump sum of 3 x £6,825 = £20,475, plus John’s wife will start to receive a pension of £5,850 pa (50% of the unreduced pension), which is payable for her lifetime.
Most public sector schemes such as NHS, Teachers Pensions and many local government pension schemes, conform closely to this format, however since 2014, many have changed to a career average basis (CARE) to calculate benefits. Members earn a fraction of their earnings for each year which is increased in line with government published rate of inflation. These are accumulated each year to arrive at final pension entitlement. One of the biggest differences is that transfers are not available from unfunded schemes (e.g. NHS, Teachers schemes) unless going to another defined benefit scheme. Generally local government schemes do still allow transfers to a flexible pension plan.
Private sector schemes are much more varied and it is much more important to fully understand the benefits a member is entitled to. Each scheme will have their own individual combination of benefits covering the whole spectrum of how benefits are accumulated, how they increase in deferment for leavers and in payment from retirement, death benefits available, and entitlement to early or late retirement. Private sector schemes are also more susceptible to financial insecurity of the sponsoring employer.
What are the typical challenges that clients approach you with in relation to transferring their defined benefit pension?
Many clients are now much more aware of the options that are available from personal pensions with the introduction of pension freedom legislation. There is now much more coverage in the media, and availability of information via internet, informing consumers of the benefits of flexible benefits in retirement, and current high transfer values has prompted a huge increase in enquiries for advice.
The main areas of concern are:
- Flexibility & control – Many more people have a different outlook on retirement rather than working to 65 and then stopping there. People would like to consider winding down or even the possibility of a career change from a stressful job to something more enjoyable. Pension freedoms offers many more options that may be more suitable, however these are not available through a defined benefit regime.
- Availability and value of death benefits – Demographics have changed significantly in recent years and the traditional model, based on nucleus family, no longer works for many people. Families often have complex relationships where it may not be easy to identify financial dependency for one individual. Scheme rules vary significantly and the availability of spouse pension, or dependent’s pension is generally at the trustee’s discretion rather than an automatic right. This is specifically relevant for anyone in same-sex marriage or civil partnership as schemes do not have an obligation to change the rules to accommodate these arrangements, and even where they do on some occasions this will only be backdated to when the law was changed therefore people who believe they are entitled to benefits may not actually receive what they expect.
- Pension taxation considerations – pension taxation has changed considerably over the last 10 years, most significantly with the introduction of the lifetime allowance and annual allowance regime. Individuals, even with relatively modest earnings but a long career or people who have large increases in salary in a particular tax year could see themselves faced with a tax bill because their annual allowance has been calculated in excess of the £40,000 limit. Anybody with a pension benefit in excess of £50,000 per annum in a final salary scheme will face an income tax charge when they take their benefits. While it’s important to understand and quantify the implications of taxation, this does not always lead to a need to transfer benefits from a defined benefit scheme, and is only one of the factors taken into account.
- Financial security of the scheme – financial security is probably one of the most topical issues in relation to defined benefit pension schemes. With recent highly publicized failures such as BHS, Carillion and most recently – British Steel, this has become a matter of great concern for many people in final salary schemes. It is important to understand that where the scheme may have a deficit, the long-term financial standing of the scheme is based on the sponsoring employer’s ability to continue funding the scheme. The employer also has a legal requirement to make provision in their accounts for any shortfall in the scheme and agree a funding schedule with The Pensions Regulator which has to be approved and details published to members.
What can happen to scheme members’ defined benefit pensions if their employers become insolvent and the scheme doesn’t have enough funds to pay their benefits?
As mentioned above all schemes are backed by an employer’s covenant, and there is a charge over the employer’s assets effectively, which can be called on to meet scheme deficits. Where the employer fails and there are insufficient assets available, then there is the option of going into the Pension Protection Fund (PPF). This is a government-backed scheme funded by other occupational pension schemes and provides a level of protection for members where the sponsoring employer has gone into liquidation or otherwise failed. There are some limitations on the benefits that will be provided, in that only 90% of the benefit is guaranteed, and there is a cap on benefits which is, £39,006.18 (equating to £35,105.56 when the 90% level is applied) per year, from 1 April 2018. This is set by DWP. It is important to note that the government does not underwrite any guarantee provided by the scheme, on the compensation paid by the PPF is limited by the funds available.
What would you say are the specific challenges of assisting clients with defined benefit schemes?
One of the main challenges is helping members to properly understand the benefits they have accrued in the scheme and their value, and to dispel some of the myths and misconceptions that are prevalent at this time. It is essential to show the benefits in a proper context, and how these compare with the alternatives available. One of the ways we do this is by using cash-flow planning to project future inflows and outflows and compare this with the financial impact the members’ financial resources. This helps to show how achievable or not the retirement plans are, and to look at all the potential ‘what if’ scenarios, especially early mortality, poor investment performance and potentially running out of money if they were to transfer the benefits.
Another challenge is to explain the loss of guarantees, on the impact of charges and investment risk. It can be difficult to see past a large lump sum and consider the actual income benefits that the plan provides. When dealing with individuals who have little or no investment experience, and possibly, this will be the first time they have dealt with financial adviser sought advice of any kind, it is important to ensure that explanations are provided in a manner that the individual can understand and that the gravity of the loss of guarantees is properly explained and demonstrated.
In the progression of your career, how are you developing new strategies and ways to help your clients?
Our approach for dealing with all our financial planning clients is the same regardless of whether or not they have a defined benefit scheme. We take a holistic approach which takes into account the stated objectives and all the financial resources. We then complete our financial analysis which establishes their needs. In this way, we not only consider what the client wants, but what they actually need in order to achieve their goals in the future.
We have developed a very detailed, client-centric process, which focuses on communication and providing high levels of professional service to our clients to achieve their ultimate goals. We continually review and amend processes to ensure continued delivery of the promised services and to improve these where we can, and we are always investigating new and better ways to improve communication with our clients.
We are also embarking on a research programme to develop a specific investment strategy to match the flexibility and challenges provided by pension freedoms and flexible drawdown.
If you could, what would be the one thing you’d change about defined pension schemes?
It would be a great improvement for members of defined benefit schemes if there was more clarity in relation to what they should expect from financial advisers in the provision of advice. Also, clarification the obligations of trustees to provide the information required to enable financial advisers to properly assess the members’ benefits as part of this process. Currently, the Financial Conduct Authority regulate financial advisers as set out the standards for the provision of advice, and The Pensions Regulator sets out the obligations for trustees in terms of the provision of a statutory cash equivalent transfer value and the information it needs to be provided with that. There are no specific rules or guidelines laid down for trustees in relation to the information that they should provide to financial advisers, and on occasions this can cause problems and delays in obtaining the information in a timely manner.
Also, from a members’ point of view, more availability of partial transfers from defined benefit schemes will be greatly advantageous. Currently, while the legislation allows this, there is no obligation on a scheme to offer this to members.
What is your overall piece of advice for Finance Monthly’s readers in regards to defined benefit schemes?
Take time to understand the value of the benefits you have, in the context of your own personal circumstances. It’s important that individuals fully appreciate the exact benefits that they, or their family will be entitled to during their lifetime and in the event of death. Being offered a large lump sum of money can seem very attractive, however that money could run out at some point is important to ensure that they have a plan B that is realistic and feasible if this happens.
Do you have a mantra or motto you live by when it comes to helping your clients with defined benefit schemes?
This is the biggest financial decision they will ever have to make and it will have an impact on the rest of their and their partner/spouse lifetime. It is a huge responsibility on the shoulders of the adviser to provide proper and accurate advice, as there is no going back once this decision has been made.