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Defining moments

This week we bring to an end our look at the main subjective and objective factors which should govern an adviser&#39s assessment as to whether an individual with a preserved pension in a defined-benefit pension scheme should transfer the value of those benefits to a private pension alternative – primarily, of course,a personal pension or a pension buyout bond.

To recap, I have been looking over these last few weeks at the four main stages in the calculation of a transfer value, being the first four of:

Identify and quantify the value of the individual&#39s preserved pension benefits, including death benefits.

Revalue those preserved benefits to the scheme&#39s normal retirement age.

Calculate the lump sum required at that time to buy those revalued benefits; Discount that lump sum back to the present value; and (in some cases) Make an adjustment for that discounting, taking into account current investment market conditions.

In this concluding article,I would now like to look at the fifth of these stages. In the latest survey from the NAPF, around 70 per cent of pension schemes in the private sector declared that they calculate transfer values in accordance with the principles laid down under the minimum funding rate. These principles are based around the stages noted in this series of articles, including the fifth stage under which the calculation arrived at after stage four is adjusted for market conditions.

This adjustment is calculated by dividing the current dividend yield on the FTSE index into the factor 3.25. Thus, for example, if the current FTSE dividend yield were to be 3.25 per cent, the factor would be 3.25 divided by 3.25 = 1. Here, there would therefore be no effect in the application of the multiplying factor.

However, at the time of writing, the dividend yield is around 2.75 per cent and so this (stage five) multiplying factor is currently 1.18. This has the effect of “increasing” the transfer value derived from stage four by around 20 per cent.

What messages does this factor hold for pension transfer advisers? Simply, if the factor falls, then so do transfer values. The factor will fall if the dividend yield on the FTSE index rises, and this can only occur either if stockmarket companies start to pay significantly higher dividends (unlikely, in the current environment) or share prices fall, which is much more likely.

In the latter respect, if share prices fall while dividend payments are maintained, then the effective dividend yield – expressed as a percentage of the share price, of course – will rise.

Thus, earlier this year, share prices fell heavily and this resulted in a significant increase in the FTSE dividend yield, leading, in course, to a reduction in the MFR-based transfer value multiplier falling and so transfer values fell heavily – typically by between 10 and 20 per cent in my experience.

Such falls are difficult to explain to preserved pension clients who would, in the normal course of events (quite understandably) expect their transfer value to rise over time, typically by around 8 per cent a year.

Clearly, pension transfer advisers must be aware of the effect of this factor, not least in the timing of their advice. It is arguably much better to request a transfer value when share prices are high.

Remember, though, that this factor only applies in this way to pension schemes which calculate transfer values in line with MFR requirements, applying to around 70 per cent of pension schemes in the private sector.

Well, that brings us to the end of this series of articles which, having covered a large number of issues over the last few weeks, prompts me to summarise the main issues we have discussed.

At the first stage, in which the calculation identifies and quantifies the value of the individual&#39s preserved pension benefits, including death benefits, the key issues are:

Does the pension scheme accrual rate include state scheme offset (which reduces the level of the accrued benefits)?

Does the pension scheme pay benefits to a surviving spouse and/or dependant and, if so, how does it define spouse/dependant for payment of these benefits? This includes the question of whether the benefits are payable to, for example, the spouse at the date of leaving or the spouse at the date of death.It also includes issues relating to the payment, or otherwise, to a common-law partner of the opposite sex or to a same-sex partner.

With regard to the above, what is the marital status of the client at present, what was it at the date of leaving service and what is it expected to be in the foreseeable future?

At the second stage, under which the preserved pension benefits from stage one are revalued to the scheme normal retirement age, the key issues are the assumed rate of price inflation, which indicates the value from the existing scheme and the possible actuarial reduction on taking benefits before scheme normal retirement age.

At the third stage, the revalued preserved pension benefits are capitalised in value, meaning that the actuary calculates the lump sum required at that time (that is, at normal retirement age) to buy those revalued benefits. The main issues here are:

The annuity assumptions, including (very importantly) assumptions as to life expectancy and future interest rates.

The inclusion or otherwise of an allowance in the calculation for the presence (where appropriate) of scheme discretionary increases to pensions in payment; and The definition of spouse or dependant, bearing in mind the client&#39s present and likely future marital/relationship circumstances, particularly in respect of common-law partners and same-sex relationships (in a similar respect to the issues at stage one).

At the fourth stage, the actuary discounts the lump sum, derived after stage three, back to the present value. In other words, what lump sum, invested today, is likely to grow in value to the lump sum required to meet the cost of the member&#39s benefits at normal retirement age?

The main issue here is, quite simply, the rate of investment growth assumed by the actuary. This will depend to some extent on the investment strategy of the particular pension fund, with a notable and topical updated example being the recent confirmation from the Boots pension scheme that it has entirely disinvested from equities (estimated future annualised returns around 7 per cent?) in favour of investment in Government bonds (total estimated returns around 4.6 per cent).

Finally, the fifth stage, present in most private sector pension scheme calculation (but few in the public sector) amends that fourth-stage calculation with a factor derived from the dividend yield on UK equities.

In summary, pension transfer advisers must be aware of many more issues – some relating to the risk of transferring but many relating to additional potential benefits, then only the one or two issues we have historically been highlighting to clients and have been taking into account in our assessments of the advisability or otherwise of a transfer.

Here we leave pension transfers, returning next week on to crucial investment iss-ues which arise from a frequent or regular perusal of the share price pages in investment publications such as the Financial Times.

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