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The starting grid

In this article, I will conclude my discussion of some of the main factors which might determine the advisability or otherwise of effecting a transfer from a final-salary pension scheme.

In my previous two articles, I concentrated on subjective factors including expected retirement age, sexuality and marital situation. Here, I will move towards objective factors, with a particular emphasis on critical yields.

Over the years, I have often been asked by pension advisers what I feel should represent a reasonable critical yield under which it would be advisable to recommend a transfer. It would therefore follow that a transfer should be rejected above that critical yield.

Indeed, I have worked for insurance companies and IFAs which almost religiously adhere to the application of what might be called a hurdle rate. However, I strongly believe they are missing the point.

I am aware that some pension advisers go through all the hard work of formulating a recommendation by collecting and collating all the required information, thence to recommend all transfers into their preferred managed or with-profits fund. However, such an investment strategy completely ignores individual client factors such as attitude to risk, the importance of this transfer within the context of overall financial situation and the term of years to expected retirement age. Surely, the adviser must be prepared to recommend different portfolios for different client circumstances and requirements?

Let me develop this point by briefly explaining the investment strategy that my own firm adopts regarding the recommended asset allocation for each client. The basic portfolio grid we have constructed is shown below. I accept that the terminology and time categorisation are fairly arbitrary but I have simplified the table for the purposes of brevity in this article.

Within this grid, it is possible to identify different principles for asset allocation within each box. Thus, for example, a low-risk client with fewer than five years to his expected retirement age should be recommended a much safer mix of assets than a high-risk client with more than 25 years to retirement.

If I start now to put a little meat on the bones of this grid, the low- risk, short-term client I have just mentioned should perhaps only be recommended a cash fund for his entire transfer value (if a transfer is recommended at all, of course).

Now, relating this portfolio grid to the issue of acceptable critical yields, a simple look at the rate of interest available on cash deposits on the money market will confirm that the highest gross rate of return a cash fund could be expected to yield is currently around 5 per cent a year. If we deduct from this gross rate an allowance for the insurance company’s charges under a typical pension transfer product of, say, 1.25 per cent, we arrive at a net rate of 3.75 per cent.

Thus, for this client, I would first of all highlight the advisability of a very secure fund recommendation, which in turn indicates the highest critical yield which might be acceptable in these circumstances. Taking objectivity in isolation, if the critical yield is higher than 3.75 per cent (and, of course, most will be) a transfer should be rejected.

As I noted above, though, there are a range of subjective factors which might drive the client to require a transfer, even though the required critical yield is highly unlikely to be exceeded. In these circumstances, I strongly believe it to be good style for the adviser to clearly and unequivocally state the subjectivity basis or bases on which a transfer is recommended and, if the client accepts the recommendation, they must firmly be aware that the future retirement fund is likely to be lower than the benefits promised by the former employer’s final-salary scheme. This not only allows the client to make a properly informed decision but it covers the adviser against a claim that the risks of a transfer were not clearly stated to the client.

If I now develop the contents of the portfolio grid a little more, if a client has a low tolerance to risk but has, say, 20 years remaining to his expected retirement age, most advisers would adopt a more adventurous asset allocation mix than that recommended for our last client. It is generally accepted that risk tends to diminish over longer periods of time. Thus, for this client, we might have a mix of assets between cash, fixed interest, property and equities – perhaps in broadly equal proportions.

Here is where the maths can get a little tricky but I believe the end result is well worth the effort. I have already noted that a cash fund could be anticipated to produce a gross annual return of around 5 per cent and similar principles can be used to arrive at assumptions for the other three asset classes.

Without wishing to be contentious, I will assume (not least for the relative ease of maths) that a fixed-interest fund in mid-range corporate bonds could anticipate a gross annual return of 6 per cent, property funds 7 per cent and equity funds 8 per cent. The composite expected growth rate for the portfolio can then be calculated, using a sample transfer value of 40,000 (see above).

I fully accept that you could argue with one or more of the illustrative expected growth rates but the principle is sound. From this gross rate, an allowance for charges should be deducted to arrive at a critical yield – or hurdle rate – for this client’s circumstances.

If the actual critical yield is higher than this figure, the client should not be recommended to transfer unless there are subjective reasons (his marital situation, for example) or specific client attitudes (such as a desire to break all ties with his former employer’s sch- eme) which he believes override the likelihood of a financial loss on effecting a transfer.

If all this sounds a little negative and the hurdle rates appear to be relatively low, then so be it unless the pension adviser believes (as I do) that the anticipated growth rates shown above are too low or (as will be the case with clients with a higher acceptance of risk) the asset allocation is too conservative.

In any event, in my firm’s experience, there are a great many occasions when we feel that subjective factors outweigh a seemingly stretching critical yield although, of course, there are some critical yields which are so high that almost no subjective considerations can make a transfer advisable.

In closing, for those pension advisers interested in the portfolio grid, you may be interested in a summary of the portfolios we recommend (see below) which is based on the principle that risk diminishes with time. You will see that you do not need to construct a different portfolio for each box.

Well, that concludes my discussion about pension transfers. In my next article, I will start to conclude my overview of a number of different developments – past and imminent – in the pension field.


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