Low interest rates: the damage to your Defined-Benefit Pension.

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March 11, 2021 - Paul Fazackerley

Low interest rates: the damage to your Defined-Benefit Pension.

Low interest rates set by the Bank of England have been great news for borrowers, but the steady fall in rates over the years has caused significant damage to Defined-Benefit Pensions, sometimes called Final Salary Pensions.

Many of these work-based pension schemes have not performed well in recent years because of low interest rates, and they now have large shortfalls in their accounts. This means that those who have yet to retire may not receive the full amount of pension income they were expecting to receive.

In the recent Budget, the Chancellor Rishi Sunak announced that pension scheme rules are to be changed to give the pension industry more flexibility to unlock billions of pounds from pension funds to invest in innovative new ventures. This is expected to give pension fund managers more flexibility, but may not be enough to resolve these existing problems.

I have a Defined-Benefit Pension: could my pension fund be affected?

It is certainly worth looking into, as large numbers of pension schemes are facing challenges. Defined-Benefit Pension schemes pay their members pension income by drawing from the scheme’s holdings. In order to meet their commitment to their pension scheme members, they need the money they hold, called assets, to grow. In the past these assets grew through a combination of the member contributions being paid in and, crucially, high interest rates. A fine balance was achieved through these higher interest rates and the population having lower life expectancy – people dying younger. Today however we have the reverse situation: extremely low interest rates and higher life expectancy, meaning pension payments are paid to their members for a longer duration. Many Defined-Benefit Pension schemes are operating in deficit, and their held assets are not growing as they used to and will struggle to pay members retiring in the future the pension income they were expecting.

This is not all down to bad management of those who run the pension scheme, and they haven’t simply made a mistake with their choice of asset class. Pension schemes are restricted by the UK Pensions Regulator in terms of how the money can be invested. The intention of these rules was to protect investors. However, ensuring the funds can not take on too much risk has in this case meant that it has been increasingly difficult to achieve the returns needed.

The good news is that there are existing protections in place for those who have Defined- Benefit Pension schemes that have shortfalls. The Pension Protection Fund protects up to 90% of a pension plan, offering financial security for those approaching retirement.

I thought pension schemes were invested in stocks and shares?

Pension schemes have relied considerably on government bonds in their portfolios for them to grow. Government bonds are considered to be lower risk and less volatile than other asset classes. Whilst this has its advantages in terms of risk, the problem is that government bonds produce a yield which is based on interest rates set by the Bank of England, and interest rates have been extremely low for a significant period of time. According to the Pension Protection Fund’s Purple Book, which looks closely at all UK Defined-Benefit pensions universe risk profiles, pension scheme reliance of government bonds increased significantly between 2006-2019, which means they have held money in bonds which have not provided the fund significant growth.

How long have interest rates been a problem for Defined-Benefit Pensions?

To put this problem into a larger context, interest rates were at their highest ever point in 1979 when the rate was 17%. By Dec 2007, rates had dropped to 5.5%, and today they are just 0.10%. This means it has been increasingly difficult for the pension fund to grow in value under these interest rate conditions. And moreover, whilst the fund hasn’t been growing as hoped, money has continued to be paid out in pension income to those who are already in retirement, and those people are living longer too. Low growth and rising financial payments out of the fund means shortfalls which will need to be addressed.

My previous employer has offered to buy me out of my Defined-Benefit Pension scheme, what should I do?

It is incredibly important that you do not accept a buy out offer for your Defined-Pension without taking independent financial advice, and from an adviser who holds the additional Pension Transfer qualification. Whilst the offer being made to you may sound attractive, moving money out of a Defined-Benefit Pension plan and into a Personal Pension may be a costly mistake. The Financial Conduct Authority holds the view that for most people the transfer out of a Defined-Benefit scheme is unlikely to be suitable. You should be considering any offer alongside other factors such as your age, your wider financial circumstances and tax implications. It should also be remembered that a guaranteed pension income is an extremely valuable part of any retirement plan, which is not exposed to the risk or fluctuations of other types of pension savings: it is why transferring out should not be made without taking independent advice.

Getting help.

If you don’t have a financial adviser working with you already on your retirement planning, then it would be worth getting your pension reviewed to get the status of the plan and to ensure you are on track to meet your retirement income expectations.

At Furnley House, our team of Independent Financial Advisers, some of whom hold the specialist Pension Transfer qualification, work with people at all stages of their retirement journey. To speak to our adviser call 0116 269 6311 or email info@furnleyhouse.co.uk

Past performance is not a reliable indicator of future performance.

The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested.

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