In looking at the objective and subjective factors aff ecting an individual's decision on whether or not it would be preferable to transfer preserved pension benefits from a defined-benefits occupational pension scheme to a private arrangement, we have now reached the second of four (or, in many cases, five) stages in the calculation of a transfer value.
Stage one in this procedure is the identification and quantification of the nature and the level of benefits accruing to an early leaver from a final-salary pension scheme. These comprise both personal benefits and death benefits, the latter being divided between lump-sum and surviving dependants' benefits.
In this article, we will start to look at the second stage in the process – the revaluation of those preserved pension benefits from the date of leaving service until the date they are due to be taken.
Here, it has traditionally been widely assumed that, if an individual with a preserved pension seeks the maximum possible level of guarantees, he or she should leave the benefits with the current scheme. However, the method of revaluation most commonly used by pension schemes is to increase those benefits by the rate of price inflation from the date of leaving to the date they are due to be taken.
This rate of increase will usually be restricted to no more than 5 per cent, this usually being known as limited price indexation.
It should, of course, be noted that most preserved pensioners have an element of guaranteed minimum pension within their benefits and these benefit from a different rate of revaluation to the (usually much bigger) excess benefits – typically at a fixed rate of revaluation (6.25 per cent for more recent leavers) or in line with increases in the level of national average earnings.
Returning, though, to the typical LPI revaluation of the preserved pension benefits in excess of the GMP, it is vital that the individual realises the absence of guarantees.
As an example, let us consider the case of John, who had 20 years of service with his previous employer, all served as a member of its 1/60th final-salary scheme. His salary at the date of leaving was £30,000 a year. He has 20 years to go until normal retirement age.
His preserved pension is £10,000 a year (20/60ths of £30,000 a year). Let us assume that £2,000 a year of this preserved pension represents the GMP and the scheme revalues this at 6.25 per cent. The remainder (£8,000 a year) is revalued in line with LPI.
Applying these revaluation rates to the preserved pension, we can calculate that John's revalued pension at his normal retirement age is around £6,720 a year in respect of his GMP and £14,450 in respect of the benefits in excess of his GMP.
These re-evaluated amo-unts are shown in the transfer analysis and will be compared with the projected pensions likely to be produced from a private pension arrangement following a transfer. Fundamentally, if the projected pension from the current scheme is higher than that projected from the alternative pension arrangement, then a transfer will look unattractive.
However, how certain can the client be that the revalued pension shown in the above example will materialise?
You see, although the fixed rate of revaluation on the GMP is absolutely certain, the revaluation of the excess benefits is far less so. In revaluing the £8,000 excess preserved pension to a new figure of £14,450, I have used 3 per cent as an estimate of future price inflation. If future price inflation falls lower than 3 per cent a year, the client's revalued pension will be lower – perhaps considerably so – than the illustrated amount.
This is the first risk the client accepts if he leaves his benefits with his existing scheme and I regret that, in my experience, this is a risk which many advisers fail to point out to their clients, thus, in all probability, leading to more clients choosing not to transfer than perhaps should be the case.
However, if inflation transpires to be greater than 3 per cent, the client's revalued pension will, obviously, be higher than the illustrated amount. On the face of it, the client's downside risk appears to be matched by the upside potential in this respect.
However, it should be remembered that the vast majority of pension schemes restrict this inflation-proofed revaluation to an annual rate of no more than 5 per cent. A sample range of possible outcomes, depending on future price inflation, is shown in the table below.
The preserved pension (in excess of GMP) will maintain its value in real terms net of inflation but, if inflation rises above 5 per cent on average from the date of leaving to the scheme's normal retirement age, then it will lose its real value. This, I suggest, is the second major risk the client must accept if he leaves his benefits with his current scheme and, again, I am aware that this risk is frequently not brought to clients' attention.
So, seemingly simple and straightforward projected pension calculations in respect of the current scheme actually mask a number of very real risks to the client.
Before leaving this stage in the calculation of the transfer value, it should also be noted that these rates usually only fully apply where the individual leaves his benefits to accrue until the scheme's normal retirement age.
Where the client seeks to take his benefits before that time, the vast majority of schemes will, after revaluing the benefits for that lesser number of years, also impose a further actuarial penalty, broadly designed to represent the additional cost of paying the pension for a greater number of years.
This penalty can typically be anything up to and sometimes beyond 4 per cent for each year of early withdrawal. Thus, a client seeking to start to draw his benefits 10 years earlier than the scheme normal retirement age could suffer a penalty of anywhere between 20 and 40 per cent, depending on the scheme's practice. This, it can be seen, could wipe out anywhere between 10 and 20 years' worth of previous revaluation.
In summary, at this second stage, there are risks to the client of leaving his benefits with his current scheme which should be brought to his attention when assessing the possible merits of effecting a transfer. If these risks are ignored in this advicegiving process, the client might well be tempted to leave his benefits with the scheme, ignorant of the possible downsides and in the mistaken belief that he is opting for the maximum guarantees option.
So where are we going over the next few weeks? Well, having finished our look at the first two stages, we will now be moving on to the third stage in which the revalued pension from the first two stages is capitalised. Put simply, the actuary seeks to determine what level of fund would be required to buy the revalued pension at the member's normal retirement age.
Before next week, you might like to start to think about the variable factors in this stage of the calculation, the impact those variables have on the calculation and the effect that the range of calculations might have on the client's eventual benefits and the merits or otherwise of a transfer.
Keith Popplewell is managing director of Professional Briefing