For Adviser use only – not approved for use with clients
Oracle April 2017
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.
continued overleaf
Transfer values
Suitability
A key figure, perhaps!
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?
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’.
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!
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.
continued overleaf
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…
continued overleaf
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?
continued overleaf
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 tradeoffs they are making to achieve their
objectives and the desirability or
otherwise of alternative solutions?
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.
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.
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?
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.
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.
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’
www.gov.uk/government/uploads/system/uploads/attachment_data/file/2
94796/freedom_and_choice_in_pensions_ print_210314.pdf
FCA consultation: ‘Pension Reforms – Proposed Changes to Our Rules & Guidance’
www.fca.org.uk/publication/consultation/cp15-30.pdf
www.pruadviser.co.uk
“Prudential” is a trading name of The Prudential Assurance Company Limited (which is also used by other companies within the Prudential Group). The Prudential
Assurance Company Limited is registered in England and Wales. Registered Office at Laurence Pountney Hill, London EC4R 0HH. Registered number 15454.
RETS10285_ARTICLES_c 04/2017
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.
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?