If you work for a good employer, you have probably been offered a workplace pension scheme of some kind. This could be a ‘defined benefit scheme’ which is common in public sector jobs, or a ‘defined contribution scheme’ which is becoming the default scheme offered to private sector workers.
In either case, you are probably sent a handful of leaflets about the scheme when you join the company, and hear little else about it for the rest of your career.
After multiple employer moves, you may find yourself with 3 – 5 pots of pension money sat with as many different pension providers. Each charging their own fees and administration charges on that money. This can become tiresome to manage and difficult to keep track of.
Comparing Financial advisers could help by giving a formal recommendation on how to combine these pension pots into one, easy to manage location.
The advantage of doing so is of course simplicity, but you could also receive an investment boost by picking the absolute best of the lot to focus your funds into. After all, if one scheme charges significantly lower fees than the others – you could see an instant reduction in fees by consolidating into that provider.
However, this is a very very hairy area for pension investors because of the complex terms and conditions that are attached to each pot. It’s safe to say that pensions are far more complicated than a bank account, and the costs of making a poor decision could be devastating.
Leaving a Defined Benefit scheme can be an expensive mistake
For example, defined benefit schemes are the type where you are promised an annual pension income into perpetuity, often linked to your average or final salary you achieve within the company.
What is happening more and more at the moment is that employers are finding these schemes too expensive to run (i.e. their benefits are so generous that employers are having to continuously plug deficits in the scheme by making more payments than originally anticipated).
As a result, employees may receive a letter where the employer offers to transfer the employee into a simpler defined contribution scheme (which is more like a normal stockbroker account where you can see your pension pot rise as payments are made into it).
It is difficult, even impossible, for a person with a non-financial background to compare the costs and benefits of these two schemes. One offers a guaranteed (ish) income, whereas the other offers a value of assets.
Comparing a DB Scheme with a DC Scheme
To compare the two properly, you will need to convert the DB scheme into an ‘asset equivalent’ (i.e. what value of investments would you need to hold to produce the same level of income), or convert the DC scheme into an ‘income equivalent’.
Both of these exercises require care, because of the different risks of each scheme. A fair comparison must adjust for these risk differences also.
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Let me explain that further with an example to illustrate. Let’s imagine that you have a DB scheme which promises an annual payment of £34,000 per year in retirement. You might perform research and understand that an investment in the stock market would yield an income of 4% per year from dividends.
Therefore you might calculate that the asset equivalent of the DB scheme is £850,000, because if you invested that sum in the stock market, you could expect to produce an income fo £34,000 per year.
However, that dividend income would have a higher risk than the pension income, which is essentially guaranteed. Yes, pension schemes can sometimes collapse and not all of the income is protected by insurance or compensation schemes, but it’s altogether safer than dividend income, which can fluctuate heavily during market turmoil.
Therefore you could argue that a portfolio of £1.6m is a fairer asset equivalent because this sum invested into a low-risk asset such as government and corporate bonds would produce £34,000 in income per year.
This is just one illustration to show how difficult it can be to compare pensions accurately. Is the DB scheme worth £850,000 or £1.6m?
This is why financial advice is strongly recommended. A pension specialist will be able to explore the different options available to you, and recommend the course that they feel will maximise your retirement income or your financial security during your later years.