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Match point

I am now reaching the end of this discussion of some of the main objective and subjective considerations in the calculation of a transfer value from a preserved defined-benefit pension. Particularly, over the past few weeks, I have concentrated on the impact these considerations have on an analysis as to whether or not a client with such benefits should be advised to transfer them to an alternative private pension arrangement.

The stages into which I have divided the calculation process run as follows.

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 match those revalued benefits.

Discount that lump sum back to the present value.

In some cases, make an adjustment for that discounting, taking into account current investment market conditions.

Last week, I neared the end of stage three in this process – the calculation of the lump sum which is estimated to be required to provide the client&#39s revalued preserved pension rights when he reaches normal retirement age. We have, therefore, looked at the level of future interest rates, assumed life expectancy and the level of increases to pensions in payment (noting, in particular, the presence of discretionary increases), so we now conclude this third stage by looking at the value of death benefits payable to surviving dependants.

To an extent, the core issues here are similar to those I covered in a previous article in these pages – notably, the scheme definition of spouse or dependant contrasted with the likely marital situation of the client at the scheme&#39s normal retirement age. So I will only briefly go over these points again to bring them into the specific context of this calculation process.

Basically, in calculating a transfer value, the scheme actuary will usually assume, in determining the value of spouse&#39s and dependants&#39 pension benefits, that 75 per cent of members with preserved pensions will still be married or will otherwise qualify for dependants&#39 pension benefits at the scheme&#39s normal retirement age. By “otherwise qualify”, I am alluding to the practice of many schemes to allow the payment of a survivor&#39s pension to a common-law partner of the opposite sex or a same-sex partner.

I believe it is important, therefore, for the pension transfer adviser to identify the scheme definition of spouse and dependant to ascertain whether the client is likely to qualify for that benefit at that time.

If such qualification looks certain or likely – which I accept will be easier to define where the client is close to the scheme&#39s normal retirement age but much less so for younger clients – then the transfer analysis should quite correctly be processed on the basis of the current scheme granting a spouse&#39s/dependants&#39 pension. However, if it seems certain or highly likely that the client will not derive any benefit from this scheme feature, then it might be in his interests to effect a transfer to a private pension under which he may be able to buy at retirement a single-life pension, with the transfer value enhanced because of the notional value of the spouse&#39s benefit, or a survivor&#39s pension stating his or her own nomination of beneficiary.

The particular circumstances to which I am alluding here include individuals who are living alone and those in common-law or same-sex relationships where the scheme does not recognise such partners for dependants&#39 pension benefits.

I have talked on this particular point at a number of conferences and seminars, often to be met with suggestions from delegates that it surely cannot be acceptable to ask the client his marital intentions for the future, for example, if there is a possibility of divorce in the foreseeable future or the likelihood of marriage. I disagree.

An even greater number of delegates have voiced some disbelief that it could be acceptable to ask a client&#39s sexual inclinations. Here, I even more strongly disagree. It is only by ascertaining a client&#39s sexuality and his or her future relationship/marital intentions that a complete picture as to the advisability of a pension transfer can be made.

Well, this brings us to the end of the four main considerations relating to the third stage in the calculation of a transfer value. By now, taking into account all the issues from the first three stages, we have arrived at an estimated lump-sum value which is expected to be sufficient to provide the preserved pension member&#39s revalued benefits, including death benefits, as noted above.

The final stage – subject to a further consideration which I will look at next week in concluding this series of articles – is to discount that future lump-sum requirement to today&#39s value. In other words, what lump sum, if invested today, is likely to grow in value between now and normal retirement age to the estimated fund derived by the end of stage three in our process?

This will, of course, depend on the rate of growth assumed over this period, with the answer being known variously as the transfer value, the cash equivalent or, especially among divorce lawyers, clearly hedging their bets on the differences in terminology, the cash-equivalent transfer value.

If, to continue an earlier example, the projected required fund 20 years from now is £400,000, the transfer value will then be determined by the assumed rate of growth. Historically, scheme actuaries have been allowed great discretion in their selection of an assumption at this stage, with a reasonably typical range providing the transfer values shown in the table (below left).

It can be seen that, even where the actuaries have arrived at the same valuation by the end of stage three, the impact of their assumption in stage four – known as the discount rate – is tremendously significant in pension transfer assessments. The higher the discount rate used by the actuary, the lower the transfer value and the higher the critical yield.

Given a transfer value of less than £60,000, trying to match £400,000 worth of benefits in 20 years time is obviously a hugely testing target. Conversely, a transfer value of over £180,000 could be seen as extremely generous and likely to lead to a positive transfer recommendation.

In fact, it should be noted (albeit a little simplistically) that, with the most notable exception of an allowance for charges, the discount rate used by the actuary in this stage four calculation will more or less equate to the critical yield revealed by a transfer analysis.

You will note, however, that I have deliberately and importantly stated that actuaries have historically been given wide discretion in their choice of discount rates. In recent years, they have been required to use specified assumptions (or, rather, only a narrow band of possible assumptions) in the calculation of transfer values under the minimum funding requirement.

Schemes are now permitted to use no less favourable basis than this MFR basis for calculating transfer values, as we will see next week. At that time, in the concluding article of this series, we will look at the importance of guarantee dates for transfer values in consideration of the way in which fluctuating equity markets drive changing valuations.

Keith Popplewell is managing director of Professional Briefing


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