Generous new tax rules have led to a surge in savers giving up their final salary pensions in favour of lump sums that can be left to their children without inheritance tax being due.
The ability of savers to move money in final salary schemes to other types of pension that can be passed on to their heirs is fueling a £50bn boom in transfers, financial advisers report.
Members of final salary schemes, which are also known as “defined benefit” plans and pay a guaranteed retirement income based on salary and length of service, have always had the right to swap them for a “defined contribution” pension pot, which is a sum of money that would normally be invested to produce an income or used to buy an annuity.
But until recently demand for such transfers has been muted because the inflation-linked income provided by final salary pensions was seen as the “gold standard” and because the transferred money would attract punitive taxes if passed on at death.
However, greater control over transferred pension pots as a result of the “pension freedom” reforms introduced in 2015 and other tax changes, along with historically generous offers to those who ditch final salary schemes, is tempting more people to do so.
Over the past two years around 210,000 people have moved pensions worth £50bn out of final salary schemes, estimates Mercer, the actuarial firm. The abolition of the “death tax” on unused pensions, which took place alongside the pension freedoms in 2015, is one of the key reasons for the surge, advisers say.
This change to pensions’ “death benefits” has not received as much fanfare as the new ability to cash in an entire pension, but is arguably a bigger perk.
“The three reasons people want to transfer out of final salary pensions are the new flexibilities, greater investment choice and the death benefits,” said Alistair Cunningham, a pension specialist at Wingate Financial Planning.
“If you look at it simply, in a final salary scheme you might be getting £30,000 of annual income. If you die, your spouse will get maybe £15,000 a year.
“Alternatively, in a defined contribution pension you could pass on £1m tax free to your spouse or children if you die under 75. True, most people don’t die under 75 and you can sometimes replicate those death benefits using life insurance, but that’s how the public understands it.”
Another advisory firm told Platforum, a research company: “We write five transfers a day. The biggest change is the death benefit.”
People with final salary pensions are realising that the taxation of unused pensions on death is far more generous under defined contribution arrangements.
Final salary schemes will typically pay a “spouse’s pension” after death worth half or two thirds of the original member’s annual income.
Normally the pension will die entirely on the death of the surviving husband or wife – children will not receive anything unless they are under 23.
Conversely, money held in a defined contribution pension can potentially cascade down the generations indefinitely. This is because the pension “death tax” was abolished in April 2015.
Previously, unspent pensions faced a tax charge of 55pc, more penal than the 40pc inheritance tax rate.
Now they will pass on entirely free of tax if the saver dies before the age of 75. If the member died after the age of 75, tax is paid at the income tax rate of the person who inherits the pension, or a flat 45pc if it taken as a lump sum. The inheritor can access the money immediately, rather than waiting until their own retirement.
With careful planning around when income is taken, this means that pensions can sometimes be drawn down free of income tax, too. The generous rules mean that it can make sense to exhaust all other assets, including savings accounts and Isas, ahead of pensions. Money held in pensions does not form part of your estate for inheritance tax purposes.
IHT is charged at 40pc on an individual’s assets over £325,000. For the 2017-18 tax year there is an extra £100,000 per person allowancerelating to the family home. By 2020-21 a couple will be able to pass on a £1m property tax free.
How an insurance policy could help
If you are going to face a substantial IHT bill anyway, it may be worth taking advice about whether some of the transferred money could be better spent on a life insurance policy that will pay a tax-free sum on your death to cover the bill. Overall, this could result in a smaller tax liability.
Alternatively, you could keep your final salary pension and buy such a policy to reduce your IHT bill.
A non-smoking male aged 50 could set up a policy guaranteed to pay out £100,000 on his death for a fixed premium of £88 a month through Scottish Widows, for instance.
How to pick the right adviser
Government rules mean you must seek advice from a regulated financial adviser before you give up a final pension worth £30,000 or more.
It is common to be offered a “transfer value” of 30 times the annual income produced by a final salary scheme, so you may need to take advice even if your pension is expected to pay just £1,000 a year.
Only specialist advisers are allowed to work in this area and charges can be high. You might pay, for example, 1pc-3pc of the value of the transfer, so moving a £1m pension pot could incur fees as high as £30,000.
Some advisers will charge only if the transfer goes ahead, so there could be an incentive to recommend a move.
Telegraph Money readers have run into problems when an advisory firm declines to facilitate a transfer that it refused to recommend. Some pension companies may also be unwilling to accept a transfer when the adviser has not recommended it.
However, the rules are clear: if can prove that you have taken advice it does not matter whether it is positive or negative, you have the right to transfer.