The final nail for final salary?

Landmark pension changes which came into force last month could not have come at a better moment for those companies looking for new ways to contain the cost of pension promises.

New reforms, giving savers full flexibility to spend their pension pot as they wish, came into force just as the aggregate deficit for corporate defined benefit pension schemes soared to £292bn in March.

Members of DB, or final salary, schemes have always had the option to cash in the pension promised by their employer. But the regulator's position has been that it is rarely a good idea to give up what is nowadays considered a "Rolls-Royce" pension offering guaranteed, inflation-proofed income, which continues to pay to a spouse.

But the April reforms, which granted savers full freedom to cash in defined contribution savings from age 55, and other tax changes, have created incentives for a rethink.

Members of DB schemes cannot directly take advantage of the new flexibility and must transfer to do so.

With total corporate DB pension liabilities now estimated at £1.5tn, some are talking about the freedoms as a "new dawn" for liability management - in other words cutting the cost of future payments. A reduction in liabilities from members transferring would reduce the pressures on sponsoring employers.

The government says it has put in place measures to safeguard against a repeat of the scandals of the late 1980s and early 1990s, where employees were wrongly advised to shift out of company schemes and into personal ones.

But there are still concerns that weak safeguards and "head turning" cash offers to transfer are putting a new generation at serious risk.

In setting out the reforms, the government and Financial Conduct Authority estimated that the freedoms could lead to an extra 6,000-15,000 DB to DC transfers annually. Before the reforms coming into force in April, the ONS estimated 20,000 transfers were taking place each year.

However, there are signs that these estimates are woefully low. Next week, Mercer, which administers pensions on behalf of a million scheme members, will reveal that it has received 22,000 requests for transfer quotations since the end of February last year, a 60 per cent increase year-on-year.

"It's clear that these changes have appealed to a number of people," says Matthew Demwell, UK head of member options at Mercer. "However, these are just quotations. It remains to be seen how many people will actually accept the quotation and transfer out of their defined benefit scheme."

Scottish Widows, a pension provider, has seen a 70 per cent year-on-year rise in transfer valuations it has undertaken.

"There is also evidence that some independent financial advisers (IFAs) will now even revisit previous transfer requests to inform clients that the rules have changed," the company says. "We have also seen some activity from advisers moving customers out of the unfunded public sector schemes before the April 6 deadline."

In spite of the received wisdom that it is better for most to stay put in a DB scheme, advisers say a "perfect storm" of factors is intensifying interest in abandoning final salary pensions.

Changes to the taxes levied on pension funds at death have made it more attractive to keep money outside DB schemes for those wishing to pass their funds to children.

Another issue is the transfer valuations being offered to members.

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Hugh Nolan, chief actuary with JLT Employee Benefits, says some transfer quotations put on the table at the moment are very generous. "I'd estimate that valuations are up 35 per cent compared with five years ago."

Transfer values are high for the same basic reason that annuity rates are so poor and scheme deficits so big: low gilt yields. Pension accounting conventions mean that as yields fall, so transfer values rise.

"People know that the current transfer deals may not last if gilt [yields] rise and are asking whether they should lock in the windfall," adds Mr Morrison, although he adds that the transfer deals on the table could not buy a matching annuity on the open market today.

Punter Southall, a firm which advises employers on pension funding, recently described the freedoms as a "new dawn" for pension liability management. "Transfer values may be in a number of members' interests," says Joanne Livingstone, technical director at Punter Southall.

And she adds that for a company, having employees cash out may be a cheaper way to de-risk pension schemes than transferring the liabilities to an insurance company, improving the scheme's underlying funding position.

Aware of the new opportunity to plug pension deficits, some employers are liaising with trustees regarding policies on transfer values. Some are requesting that trustees quote transfer values alongside value-at-retirement quotes, something that has not been standard practice. Others have left these decisions solely in the hands of the trustees.

In another new development, scheme rules are being changed to allow partial transfers.

"Our survey last month of over 320 employers and trustees found that 75 per cent of schemes expect to quote the transfer values as part of the standard retirement quotation," says Stewart Hastie, a pension partner with KPMG.

"Around 30 per cent are expecting to permit partial DB transfers - in other words, keeping a lower level of DB pension and flexing the rest."

Mr Hastie says that in his experience about 25 per cent of eligible members take a transfer value at retirement and purchase a different retirement income. He thinks the new freedoms might drive take-up to a third "on the basis that members get support in understanding their options and access to IFA advice where appropriate".

"Scaling this up to the UK's private sector liabilities, we could see some £250bn discharged from private sector DB schemes over the next 10 years," he adds.

The fundamental tension between employers' desire to reduce their pension liabilities and trustees' responsibility to do the right thing by members is causing tensions among those charged with looking after members' best interests.

"The philosophical battles are really raging among trustees now," says Mr Nolan. "We have had meetings where the trustees are very split on this. Some trustees are saying we should highlight the transfer option, and others say no we shouldn't."

Calum Cooper, partner and head of trustee defined benefit with Hymans Robertson says: "There's a fine line between making members aware of their options and being seen to encourage transfers.

"Our recent research showed almost half of large UK employers are worried about being held liable for failing to prevent employees from making poor decisions through transfers.

"In that context, employers and trustees must ensure that scheme members have good support to make choices that are right for them. Trustees owe a duty of care to members, but it is also just the right thing to do. The last time we had a rush of transfers out of DB schemes in the late 1980s, it ended in tears. We need to learn from the past."

In this environment, there is also pressure on the regulator to change its position that it is rarely a good idea to give up a DB pension.

"The regulator's sabre-rattling is frustrating the policy intention that the chancellor had set out," says Mr Nolan. "However, I am not saying that transferring out is for everybody and I am all for members getting good advice."

In an interview with the FT in March, pensions minister Steve Webb said barriers were in place to prevent a repeat of the Thatcher-era mis-selling scandal, which saw an exodus out of DB schemes, resulting in £11bn compensation claims.

Now individuals with transfer valuations of £30,000 or more must show they have obtained independent financial advice before a transfer can proceed - and nervous providers are also creating barriers to transfers. A survey by the FT (see table) found just six out of 14 pension providers would accept a transfer from an insistent customer, or one who wanted to transfer against the recommendation of an adviser.

But there are warnings that the safeguards are too weak. "Inevitably, individuals with transfer values below £30,000 will be more susceptible to being lured into superficially attractive arrangements, potentially accepting enhanced transfer values that are not as generous as they might at first seem," comments Ben Fairhead, partner with law firm Pinsent Masons.

"There have been issues in the past where employers have offered enhanced transfers and there have been concerns about members not getting good deals.

"It is these individuals who, without the benefit of independent financial advice, will be more vulnerable to fraudsters, encouraging them to transfer their DB pension into the DC arena and thereby take advantage of the new freedoms available for those reaching age 55."

Ros Altmann, a pensions expert and the government's older workers champion, believes the £30,000 cut off is too high. "Advice should be required to help anyone with pension rights worth more than, say, £10,000 understand what they are giving up," she says.

While the high volume of transfer quotes are not yet translating into a stampede of transfer requests, this could change.

Mercer expects its transfer quote volumes to head higher as increasing numbers of employers are willing to pay for at least some advice to help members decide what to do.

"The process must be carefully managed," says Mr Denwell. "But it's clear that, now the 'freedom and choice' genie is out of the bottle, things won't be the same again."

In spite of new safeguards, experts in pensions history worry that mistakes from the past have not been learnt. "I suspect this will not be 'mis-selling' in a legal sense, but I do have concerns that a large number of DB members will end up bitterly regretting exercising their right to 'pension freedom'," says Hugh Pemberton, a historian and pension specialist at the University of Bristol.

"It will turn out to be the freedom to mess up their experience of old age, perhaps catastrophically so."

For many years, the official advice has been that it is rarely in anyone's best interests to abandon a defined benefit pension. Only those in poorer health, or with no spouse or dependants, were thought to be potentially better off from quitting a "final salary" plan.

These traditional company pensions, offering guaranteed, index-linked benefits which continue to pay to a surviving spouse, are considered "gold-plated" and rarely offered within private sector schemes today.

The employer offering a final salary scheme is responsible for continuing to meet the pension promises, with no investment risk borne by the member, and if a private sector employer goes bust, there is a safety net in the form of the Pension Protection Fund.

But as the cost of meeting final salary pension promises has grown to record levels, companies have sought to contain future liabilities by offering members deals to cash in their benefits today.

And some advisers say two coalition reforms - the pension freedoms and significant changes to how pension funds are taxed upon death - have been a "game-changer" for employees.

"The pension freedoms and death benefit changes have created further discussion in relation to potentially transferring out of final salary schemes, particularly for those who are divorced or widowed," says Gary Smith, a financial planner with Tilney Bestinvest.

Mr Smith explains that changes to death benefits, which came fully into effect on April 6, have made it more attractive to keep money in pension drawdown or a self invested personal pension (Sipp) compared with a defined benefit pension or an annuity (without money-back protection).

The changes mean that if an investor in drawdown, or a Sipp, dies before age 75, the fund can pass to any nominated beneficiary free of tax. From age 75, the fund can pass to beneficiaries with payments taxed at the recipient's marginal rate.

<>"If someone is divorced or widowed, if they die the day after getting a final salary pension then their children typically won't receive anything," added Mr Smith.

"If the member moves their pension into a Sipp or drawdown, when they die their children can inherit their pension. This is very important to some people."

However, Mr Smith added: "Our starting point is always that final salary transfers are a last resort, as the ability to meet the individual's income requirements in retirement should supersede the desire for children or grandchildren to receive a lump sum on death."

Advisers say a combination of the "phenomenal" transfer valuations being offered by many (but not all) DB pension schemes and the freedoms is stoking interest in transfers.

But many say they would need a lot of persuading before giving any client the green light to abandon a DB pot.

"We would think long and hard before we gave a positive transfer recommendation as our default position is for clients to walk away," says David Woodhouse, head of advice services with Chase de Vere, the independent financial advisers.

"It may well be that members are seduced by the new freedoms but when you look at the secured benefits, and start to break down the offer and the option, then in nine cases out of 10 it's best to stay put."

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