The Pension Transfer With a Guaranteed Annuity
Malcolm, 58, has a defined benefit (final salary) pension with a scheme pension age of 65 and a projected pension of £18,000 a year, index-linked in payment. He also has a small personal pension worth £40,000. He has been quoted a cash equivalent transfer value (CETV) of £540,000 for the DB scheme and wants to transfer the whole DB fund into a personal pension so he can 'take 25% tax-free cash now and invest the rest'. He has a mortgage of £120,000 and no other significant savings. He is a higher-rate taxpayer in the years he works. His adviser notes the CETV is above the £30,000 threshold that requires advice.
1. Explain why the CETV being above £30,000 matters, and what advice process must be followed.
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A CETV above £30,000 for a DB scheme brings the transfer within the mandatory advice requirement: the member must take advice from a suitably qualified adviser (in the UK, a pension transfer specialist with the appropriate permission) before the transfer can proceed. The scheme cannot process the transfer without confirmation that advice has been given.
The advice must be a genuine, documented assessment of whether the transfer is in Malcolm's best interests, not a rubber stamp. It should cover:
- The value of the safeguarded benefits being given up (index-linked £18,000 a year from 65, plus any spouse's pension and death benefits).
- The critical yield - the investment return the personal pension would need to achieve to replicate the DB income.
- His attitude to risk, capacity for loss, health and life expectancy.
- The loss of the index-linking and the scheme's investment and longevity risk.
The adviser must be independent of the receiving scheme and must document the recommendation. Where the recommendation is not to transfer, the file should show why.
2. Evaluate Malcolm's plan to take 25% tax-free cash now and invest the remainder, given his mortgage and tax position.
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Key points:
- Tax-free cash: taking 25% of £540,000 = £135,000. But the tax-free cash is only available from a personal pension; by transferring he exchanges a secure, index-linked £18,000 income for a fund exposed to investment risk.
- Critical yield: to replace £18,000 a year index-linked from 65, the fund must grow substantially; index-linked DB income is expensive to replicate, and the required return is likely to be high and uncertain.
- Mortgage: he could use cash to repay the £120,000 mortgage, but that consumes most of the tax-free cash and leaves no income replacement. Repaying a mortgage with pension capital is a lifestyle decision, not automatically an investment one; the mortgage rate should be compared with expected returns and the loss of the DB income.
- Higher-rate taxpayer: the tax-free cash is tax-free, but any income drawn from the remaining fund is taxed at his marginal rate. Drawing income while still working at higher rate is tax-inefficient.
- Loss of safeguards: no index-linking, no scheme-backed longevity protection, and the fund is exposed to sequence-of-returns risk.
Judgement: the plan is driven by the attraction of a lump sum, not by a needs analysis. On the facts (secure index-linked income, modest other savings, mortgage), a transfer is unlikely to be in his best interests. The advice should recommend not transferring, or at most transferring only if a genuine need (e.g. ill health, no dependants, scheme underfunding) is established.