Risks associated with transfers from final salary schemes

She says the former employer has the responsibility for providing benefits irrespective of investment performance or contemporary annuity rates.

The cost, potential loss of benefits and risks of transferring from a defined benefit pension scheme to a defined contribution pension scheme often outweigh the advantages, Helen Dreyfuss, principle technical specialist of the Pensions Advisory Service, adds.

If an individual decides to transfer out of their workplace defined benefit pension scheme the trustees must convert the benefits built up into a cash sum, called a transfer value - also known as a cash equivalent transfer value (CETV).

Ms Dreyfuss warns with a transfer to a personal or stakeholder pension, an individual will give up any benefits they had in the former employer’s scheme.

The pension income they get at retirement will depend on:

1) the amount they invest (the transfer value and any further contributions)

2) the investments they choose and how well they perform

3) the charges taken out of the plans.

4) the amount of retirement income their fund can buy at retirement (annuity rate).

Any illustrations of the possible benefits payable at retirement are not guaranteed, therefore benefits can be vastly different than anticipated. The cost of buying an annuity has also steadily increased over recent years, which means a member’s pension fund will buy less pension.

The cost of these changes fall on the member in a money purchase scheme, but on the employer in a final salary or career average scheme.

Final salary and career average schemes provide defined benefits based on a fixed formula, with reference to a member’s completed service and earnings.

When an individual leaves service prior to retirement their benefits are normally revalued between the date of leaving and retirement in line with inflation.

The trustees are responsible for managing any funding risks associated with final salary and career average schemes. The trustees must ensure their schemes are sufficiently well funded to meet their liabilities - members are just required to pay their own contributions.

Risks with defined benefit schemes

But Ms Dreyfuss points out staying in a defined benefit pension scheme is not risk free.

Some defined benefit scheme members have, in recent years, lost some or all of their retirement income as a result of their employers becoming insolvent or simply winding up their schemes.

The last few years have also seen changes to pension law, Ms Dreyfuss points out. Now, final salary and career average scheme members are largely protected from the problems that affected other members in the past.

If an employer is still in business, she says it usually has to make sure the scheme has enough funds to provide the full entitlement to members. If an employer is solvent but voluntarily winds up the scheme, Ms Dreyfuss says they have statutory funding obligations and must fully fund the purchase of the members’ benefits.

If there is a funding deficit, as is likely, Ms Dreyfuss says employers are obliged to pay into the scheme whatever is required to fully fund the transfer of liabilities.

While the Pension Protection Fund (PPF) may pay compensation to members of schemes where an employer is insolvent, Ms Dreyfuss warns the member may not receive 100 per cent of their entitlement.

For example, if the member is under their scheme’s normal retirement age, she says they may only receive 90 per cent of their benefits.

Ms Dreyfuss adds here is also a cap on the amount of compensation that a member may receive from the PPF – at the time of writing this was currently £31,380.04.

Transfer values may be reduced where the pension scheme is in deficit, she adds.