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The final frontier

I will conclude my series of articles on topical issues in pension planning by providing a summary and overview relating to the transfer of pension rights from final-salary occupational schemes.

The main issues I will cover are the selection of dependants for death benefits, the availability of tax-free cash, security of benefits, including the Pension Protection Fund, and the outlook for future investment returns.

First, then, the selection of dependants. Almost all these schemes promise to pay a pension to a dependant of a deceased scheme member on death before or after the scheme’s normal retirement age. Furthermore, a lump-sum death benefit is almost invariably payable on death before retirement although this promise is not usually maintained where the member has left the employer’s service and has been granted preserved pension rights.

It is worth remembering that many pension schemes will only pay a spouse’s pension to a legally married partner. Although many other schemes’ rules permit the trustees to pay this pension to a common-law partner, far fewer permit the trustees to consider payment of this benefit to a same-sex partner.

As from April 6 this year, the Civil Partnership Act gives legal entitlement to a spouse’s pension for couples registering their relationship under the terms of this legislation. Even where the scheme rules do not exclude the payment of the dependant’s pension to unmarried partners – whether of the opposite or the same sex – the member and his financial adviser must remember that the benefit payment is entirely at the discretion of the scheme trustees, who will use their discretion, depending on factors such as the term of the relationship,the absence or presence of joint financial commitments (primarily a mortgage) and whether or not the couple have dependent children.

The death benefits from a final-salary scheme will be worthless for any early leavers.

Do not forget that, quite apart from members who are not married, there will be many married people who will at some future stage get divorced or separated. The scheme rules may still give entitlement to the survivor’s pension to the person to whom the member was married at the date he left service, as opposed to the person to whom he was married at the date of his death.

Effecting a transfer, then, gives the member the right to nominate for death benefits whosoever he chooses. This nomination can subsequently be changed as many times as appropriate, as I am certain all readers will be aware. The death benefits from a transfer value of, say, 50,000, could therefore be valueless to many deferred pension scheme members if left within the existing scheme but potentially valuable if transferred.

As a very quick example, I had a (smallish) preserved pension with a company which I left when I was first married. The scheme definition of spouse was the spouse at date of leaving. I then divorced and (unfortunately) remarried. Had I died, the spouse’s pension would still have been payable to my first wife had I left the benefits with that scheme.

I subsequently (and thankfully) became divorced from my second wife, so even if the scheme rules gave entitlement to the spouse at date of death, there would have been no benefit pay- able. Instead, I transferred my benefits to a personal pension and initially nominated my second wife to receive the value of my pension fund in the event of my death. On getting divorced (or, in fact, well before the date of the divorce, as we had hated each other for many years), I changed this nomination to favour our two children.

Whatever my future relationships may bring, I can then change this nomination again. Even if I had stayed happily married, I might have nominated my children for this benefit in preference to my wife for inheritance tax planning purposes – a point worth thinking about for all married members of final-salary pension schemes, whether early leavers or still in service.

In conclusion, I firmly believe that this flexibility of nomination for death benefits often represents a major potential factor in favour of effecting a transfer from a final-salary scheme to a personal pension, the benefit of which, it must be noted, is not reflected in the critical yield produced by a transfer value analysis.

On, then, to the availability of tax-free cash. Different final-salary schemes offer tax-free cash entitlement to early leavers in one of two ways. Either the entitlement to tax-free cash increases each year, broadly in line with the revaluation of the pension benefits, or it is frozen at the level calculated at the date of leaving.

Here, I would urge readers not to become confused by the amount of tax-free cash the scheme is entitled to pay under pension legislation. Schemes are perfectly entitled to pay a smaller amount. In my experience, very few schemes pay the legislative maximum and, in the vast majority of cases analysed by my firm, the tax-free cash entitlement increases significantly if a transfer is effected.

Most of our clients stress during our fact-finding that they attach a great deal of value to the level of tax-free cash availability, whether because they might want to use this lump sum for a one-off event such as a holiday, home improvements or new car or because they want to reinvest the money tax-efficiently elsewhere.

This increase in entitlement to tax-free cash is not usually reflected in the critical yield produced by transfer value analysis systems (with the notable exception of the excellent O&M system, either by direct subscription or through a number of pension providers) and I strongly suggest it should be highlighted independently by the financial adviser.

In summary, as regards the issue of tax-free cash, I would like to stress the importance of establishing with the scheme the amount of tax-free cash entitlement at date of leaving, the way in which this entitlement is to be revalued (if at all) to the date of retirement and, as a final point, the commutation factors used, where the scheme pays tax-free cash by commutation as opposed to schemes which pay tax-free cash in addition to a (usually lower) pension.

“Commutation factors?” you might ask. “What have they got to do with a pension transfer decision?”

I will explain more in my next article, along with an in-depth consideration about the Pension Protection Fund and, finally, a further assessment of critical yields and expected returns.

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