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Would you take a tennis racquet fishing?

Les Cameron, Head of Technical, explores defined benefit pension transfers from a technical viewpoint, tackling the topics such as transfer values and transfer drivers.

Total access to your pension fund, the reduction in tax on death benefits and the ability for non-dependants to ‘inherit’ your pension were game changers in the advice world.

In a very short period of time, it has taken two niche, high-risk advice areas – choosing drawdown over an annuity and choosing to transfer your defined benefit (DB) pension to a personal defined contribution (DC) arrangement – and placed them firmly into mainstream planning.

In this article we take a look at transferring DB pensions. It should be remembered that not all DB members have the option of transferring out to access flexibility.

A perfect storm

The government estimated in the original Treasury consultation on pension freedoms that if just 1% of public sector workers transferred their pensions it would see a cost to the Exchequer of £200 million.

Clearly foreseeing the attractiveness of transferring precipitating a flood of requests to do so, the government amended the legislation to prevent members of unfunded public sector pension schemes from transferring out their pension benefits from April 2015. Which, for many, would be their single largest asset and a life-altering amount of money.

What happened in the private sector? There were pre-transfer advice requirements added to protect members, but in the end there’s been an undoubted increase in the amount of people transferring out.

Our Transfer Value Analysis System (TVAS) service at Prudential has seen an eightfold increase in requests and, when I’m out and about and meet the occasional pension transfer specialist, they almost to a man (and woman) say they’ve never been busier!

Something else was also going on at this time. We’re in a fairly unusual place economically where both gilt yields and investment returns are low. The cumulative result being an increase in transfer values, some by quite staggering amounts. Perhaps ten years ago, transfer values would normally be around 20 times the deferred pension. I’ve personally seen one at 48 times pension, heard of one at 60 times pension, with the general consensus being low 30s being average. Essentially, they’re high!

This has all contributed to a ‘perfect storm’ making it almost irresistible with lots of people seeking to transfer out.

But should this wave have been resisted? And with the FCA stepping up commentary in this area, do you have the necessary ‘weather proofing’ to protect your business from any future advice review storm?

The FCA position has always been to start on the assumption that a transfer will not be suitable and only transfer when it’s demonstrably in a client’s best interests. In its own pension freedom consultation in October 2015, the FCA asked whether freedoms should change the starting point, particularly for those over 55 accessing freedoms. Presently, COBS is unchanged, as is the starting point! There was meant to be further work in the DB transfer area but this has yet to materialise.

So what about advice in this area? It could be a 100,000 word thesis, but in the interests of the rainforests I’ll try to keep it down.

Transfer values

A key figure, perhaps!

The cash equivalent transfer value (CETV) is calculated on an actuarial basis and takes into account accrued benefits and any options and/or discretionary benefits.

Broadly, the calculation is:

Step 1
Member’s preserved pension at date of leaving service is calculated

Step 2
This is revalued by statutory requirements/scheme rules to normal retirement age

Step 3
The capital cost of buying the revalued amount is identified using reasonable annuity rates

Step 4
The capital cost is ‘discounted’ back to arrive at today’s transfer value

The rise in values is basically down to low gilt yields driving up the capital cost, with low investment returns, the main driver of the discount, meaning we discount back to a higher place.

You’d think transfer regulations would mean there’s not much variation between schemes transfer values. However, there is scope within the regulations to allow variations, meaning there can be different values for the same set of benefits. For example, schemes may have different discount rates based on their asset mix, policies on including discretionary benefits, their membership profile and mortality assumptions could differ. One of the topical reasons is where the scheme is underfunded i.e. their assets are insufficient to meet their liabilities.

Some schemes might actually enhance the transfer value to encourage transfers out. It should be noted that where enhanced/fixed protection is held, a transfer of an amount higher than the actuarial equivalent of benefits would cause protections to be lost.

I guess all the client needs to understand is if they delay they may get less or conversely they may get more. I did hear of one person who thought their value was high as the FTSE was high!

So we get to our transfer value and in the round it might be high and that in itself could be a transfer ‘driver’.

Should we, and have we, explored a partial transfer? It may be possible and could provide the ideal mix of secure DB benefits for core needs, linked with the flexible options of DC arrangements.

Is a high transfer value a good reason to transfer? It might lessen the chances of a loss the client couldn’t absorb and it could increase the chance of being able to buy an equivalent annuity. But on its own it’s unlikely to be enough to deem advice to transfer suitable.

Suitability
Suitability is about assessing the client’s circumstances, attitude to risk and capacity for loss. You then identify needs and objectives resulting in recommending something suitable to meet them. Isn’t it?

There are many transfer drivers that I’ll cover later. Fundamentally, clients have to understand that the decision they are making is to take away the safety blanket of the scheme/employer (I’ll look at Pension Protection Fund (PPF) later) being responsible for taking on all the risks of providing them and/or their family with an income for retirement and transferring it onto themselves.

These risks could have a major impact on the client and their family’s retirement benefits and include investment risk, longevity risk, inflation risk, credit risk and capital risk. Some may be happy to take a risk with their retirement plans for the benefits or advantages it may provide. Others are ‘risk averse’, not wanting to put their retirement provision at risk. I suspect most are in between.

Wherever they fall on the risk scale isn’t the crux of the matter this? Whatever benefit or advantage they perceive on transferring their benefits should be ‘real’ and they should be willing to take on the risk of and, crucially, be able to absorb, any losses if those risks materialise. Anyone unwilling to take the risk or unable to absorb any losses should not be transferred.

The client needs to understand the risks they’re taking to understand whether they are worth the benefit.

Back to transfer drivers!

Transfer Drivers

Flexibility
There are various strands of flexibility.

There’s income shape. It should be relatively straightforward to identify if a client needs flexibility or not – just consider their expected expenditure patterns. In the 21st century it’s highly unlikely they’ll need a fixed amount of income that increases by inflation until they die. It will probably be lumpy or start high as they enter retirement, get lower the longer it goes on and then possibly increase as care/ill-health takes hold.

There’s the timing of benefits. A DB scheme may have a retirement age of 65 and not permit early retirement, other than with the scheme or employer’s consent. What if the client wishes to retire at age 60? Where early retirement is allowed, a significant actuarial reduction may be applied.

Has it been pointed out to the client that by leaving early there could be a substantial loss of cumulative income e.g. a £20,000 pension reducing by £5,000 per annum could ‘lose’ £150,000 over an average life expectancy? Does the client acknowledge and accept this? Were there any other sources of funds considered to fund the gap – why were they discounted and was it better to lose the lifetime income and take on the risk?

To conclude flexibility, within a DB scheme the available tax free lump sum may only be taken, in full, at the point the client takes the benefits from the scheme. Within a DC arrangement the client can decide to phase the payment of the tax free lump sum by only crystallising the portion of the funds required to generate the lump sum required (with associated entitlement to income). This ability to take only part of the available benefits may assist in the deferment of any possible LTA (Lifetime Allowance) charge. It would also be useful for those who may have an IHT liability and would prefer the lump sum to be in an IHT-friendly place.

Death benefits
There are two things here.

Firstly, the value of death benefits is included in the transfer value. It has always been a potential trigger for a transfer where those death benefits are not required. The individual could be single or their dependants have no need of the dependants’ pension. The value of those death benefits can therefore be used to enhance the benefits available to the individual and this could be a suitable reason to transfer.

Secondly, pension freedoms.
DB death benefits, especially for deferred members, are generally poor in both value and who can receive them. Being able to leave a quite large sum of money on your death to your loved ones is attractive. Equally, post pension freedoms, the taxation of DC death benefits is much less penal and you can also pass your pension onto non-dependants. Many clients will be attracted to this. I guess the box to be ticked is, have alternative ways of leaving a legacy i.e. protection policies been considered and ruled out? Likewise, do the family actually need the money? Should the client’s need for income security not be more important than leaving a legacy to loved ones who may not actually need the money as they’re doing OK by themselves?

Given the focus on death I’ll best cover…

Health

DB schemes don’t consider health/ lifestyle issues when establishing the level of pension income. It’s entirely possible the client could buy a guaranteed income for life of a higher amount outside the DB scheme with an enhanced/impaired life annuity.

Likewise, the client’s health situation may indicate shorter than normal life expectancy so, with longevity risk reduced, a higher income could be enjoyed following transfer than would be the case in the DB scheme.

Evidence of the former is easy, but the latter should also be covered. When did the client’s parents die? Health history? If there’s an assumption of shortened life expectancy in the advice, reasonable proof of such should be available and retained. Then there’s the health of the scheme…

Scheme health

The health of pension schemes has been the subject of many column inches. Pension scheme deficits are often trumpeted (perhaps only in the months they grow…) and there was the BHS and British Steel events and of course the recent DWP green paper.

Notwithstanding the above, what that leads to is a client who may want to transfer as they are concerned about the health of their scheme/employer. Is this a good reason to transfer?

It may well be, but what due diligence do you perform? What makes the client think the scheme is in trouble? Do we have funding statements for the scheme – is it getting better or worse? Have enquiries been made about the employer covenant – is it strong or weak and is there a repayment schedule in place? Is the Pension Regulator involved? If this is a key driver I think I’d want something on file beyond a client’s concerns. But there is another aspect – getting the PPF into context. If you transfer out you lose this protection. As we’re essentially dealing with deferred members here and without going into the whole ins and outs of the PPF, broadly speaking you still get 90% of your accrued benefit protected, but subject to an overall cap. For 2017/18 this is £38,505.61pa (£34,655.05pa when the 90% level is applied).

So, when dealing with someone with £20,000pa of pension, they’re essentially accepting all the risks on themselves to avoid a £2,000pa or 10% downside. That might be a risk trade off that’s not worth taking on. Conversely, where the pension is £70,000pa, there’s a 50% downside. A totally different conversation and analysis of risk.

Which brings me to the final driver…

Increased pension

The client may consider that their funds will grow by so much that they’ll be able to get higher tax free cash and annuity than what they could have got from their main scheme.

At least here we have the ‘help’ of one of the pillars of DB transfer advice, critical yields and TVAS.

TVAS are designed to calculate the estimated net investment growth, known as the ‘critical yield’ that an individual pension would need to achieve, after charges and using an annuity, to match the benefits provided from a DB scheme at normal retirement age using prescribed assumptions. This critical yield helps a member compare the implications of leaving deferred DB benefits with the scheme, or taking a CETV to an alternative individual pension arrangement.

A TVAS illustration is required for almost all DB transfers; except at the scheme’s NRD. The FCA specifies the process and the various assumptions that must be used with TVAS systems.

Basically, if the transfer value, less the charges, achieves the critical yield calculated by the system, the proposed receiving plan will grow enough to broadly match the benefits being given up.

There is only one problem though – a TVAS report is as of much use to a financial planner as a tennis racquet is to a fisherman. It’s of limited use. A fisherman could maybe use a tennis racquet to swat away flies; the only use a planner has for a TVAS is to keep their file ‘compliant’ and cover off one small aspect of the advice process, which could either be crucial or largely irrelevant.

Granted it’s a very important use from a regulatory perspective, but shouldn’t we be concentrating on getting the client into a fully-informed position? Does a TVAS do that?

The FCA says an over-reliance on meeting a critical yield is unlikely to deliver suitable outcomes. Their point being meeting the yield is only a small part of the jigsaw. What are the identifiable needs and objectives that are met by the transfer? Does the client understand the transference of risk to themselves? What are their attitudes to risk and capacity for loss? Do they understand the risk trade-offs they are making to achieve their objectives and the desirability or otherwise of alternative solutions?

The key things must be them understanding the ability of their funds to sustain their income, death benefit objectives and longevity risk – that’s been the FCA mantra since freedoms came along.

Isn’t getting all these things correct much more important than meeting an actuarially produced number? I would say yes, especially given it’s of limited use.

It could be of use where someone’s driver is a higher income than their scheme will provide. How many of those people exist? (I have heard of one but that was at NRD so a different story entirely).

Let’s pretend they do exist. Even if the critical yield is achieved, the benefits available under the new scheme may be less than the original scheme if any of the assumptions are different to reality, in particular if the assumptions around inflation, mortality and gilt yields are different than anticipated. Matching a critical yield achieves little.

Does a critical yield help those people we currently see transferring out? They’re transferring out for some or all of the drivers I’ve described above. A TVAS will not put these people into a fully-informed position. It aids understanding of the growth required to replicate their main scheme benefits. That’s short of a fully-informed position.

Conclusion

The FCA needs to do the further work they intended to do on DB transfer advice. Should the starting point, of unsuitable unless proved otherwise, be amended?

I don’t think it does need to be amended. The end point will be suitable or unsuitable (or unclear I suppose!) regardless of where you start. You start with an open mind, know your client and conclude whether the advice to transfer is suitable or not. There are many good reasons to transfer and many good reasons not to.

In a world where it’s looking unlikely people will ever buy a fixed income for life (well perhaps not until much later in life, time will tell) and a myriad of different transfer drivers, is a critical yield enough?

The most critical yield is “critical yield P”. That is, it’s the predicted yield of the client’s portfolio. This yield will dictate whether the client’s needs and objectives can reasonably be met. With the drivers outlined above, that’s much more likely to help a client understand what they’re undertaking than a traditional critical yield will.

But critical yields have a place. That place should be alongside something else that will get a client from a partially informed position to a fully-informed position. I’d say some form of cash flow modelling should be compulsory too.

If (when?) a review of DB transfer advice happens, I’m fairly sure I’d feel much happier with some cash flow modelling on file along with a TVAS report.

In much the same way I’d rather my fishing bag had a landing net alongside my tennis racquet!


Further reading

Original Treasury consultation: ‘Freedom & Choice in Pensions’

FCA consultation: ‘Pension Reforms – Proposed Changes to Our Rules & Guidance’

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