Transferring out of defined benefits pension schemes –from compliance no-no to acceptable advice in one leap. Compliance consultant Tony Catt analyses why advisers should tread this path very carefully indeed.
Historically, moving money out of Defined Benefits (DB) schemes was considered to be highly unlikely to be good advice for clients. In 2006/7, I was doing some pension transfer work for a firm. I looked at more than 50 cases and ended up actually transferring only two of them. This was because the Transfer Value Analysis Systems (TVAS) were calculating growth rates that were considered to be too high for the investment outside the scheme to have any chance of providing better benefits than the existing company scheme.
As far as the FCA is concerned, this issue still represents such a high risk that advisers are expected to retain pension transfer files “indefinitely”. This has raised warning lights for advisers, since it infers that complaints or regulator reviews could take place at any time in the future without any end date. This potential liability has stopped many advisers and firms from operating in this area. The Professional Indemnity Insurance providers also see this type of business as high risk and adjust their premiums accordingly.
DB schemes are still the most valuable retirement planning vessels. The guaranteed benefits are more valuable than by can be provided any other type of pension currently available. It is unlikely that taking money out of those schemes offers best value to members. However, in recent times many individuals with final salary schemes have been tempted by enhanced transfer values available, and the flexibility that the new pension freedoms regime provides in terms of gaining access to capital.
Over time, various schemes have also offered enhanced benefits for members to take their accrued benefits from the schemes. These have either been via increased transfer values or even cash payments. These enhanced benefits simply add a level of complexity to the number crunch needed to calculate whether the member would be better off to take those benefits rather than remain in the scheme. As a rule of thumb, it is unlikely that the member will be getting full benefit by leaving the scheme, otherwise the scheme sponsor would not be offering the enhancement.
Low interest rates
Let us take a look at some of the back ground detail here. We all know that annuity rates are linked to interest rates and gilt yields, both of which are sitting at historic lows This has meant that individuals get even less income when purchasing an annuity. Historically, the annual yield on the United Kingdom Government Bond 10Y reached an all-time high of 16.09% in November of 1981 and a record low of 0.52% in August of 2016. The Bank of England base rate was cut to 0.25% in August 2016 after the EU referendum. 10-year gilt yields fell to a historic low of 0.52% in August, although they have risen to 0.8% in October and recovered to 1.32% by January 2017.
While this may be bad news for those clients with DC schemes wanting the security of a guaranteed income that annuities provide, for those wanting to transfer out of a DB scheme it has provided a boost to their transfer value.
Interest rates underpin the cost of buying a pension in the market place and when you look at the transfer of a final salary benefit, the fall in interest rates has enhanced the transfer value quite considerably over a short period of time.
Anecdotally, advisers are reporting that they are seeing a dramatic increase in the transfer values that clients have been getting. One adviser I worked with had a case where the transfer value was worth 40% more than it was just over a year ago. When he looked at it before, the numbers did not stack up, but having seen such a big jump, meant it was worth considering a transfer again.
So what has changed?
You will not need me to tell you that the pensions freedoms introduced in the Budget of 2015 have changed the landscape of retirement planning and advice. The ability of people to take control over their own money in their pension plan has led to a ground-shift for advisers and also for providers too.
Our current society is more keen to go for instant gratification over good long-term decisions. Therefore, the financial services industry is tasked to provide flexibility wherever possible. Take the fast approval loan in Singapore phenomena, there it is very common and incentivised to take up such a loan. There are problems with this in that the providers are rarely able to offer all the flexibility that the government and regulators have promised to be available. This happened with some folks and their pension freedom. It’s clear that in the future some adjustments will be made to cater to this.
Pension freedom has led to a shift in emphasis; to consider the “shape” of retirement benefits. Previously we lived with the “one size fits all” annuity, which generated a regular income for people in retirement, probably after an initial lump sum was paid on retirement. The slight variations in this structure rbox out evolved around whether the regular income that was generated included any increases or guarantees or even a spouse’s benefit on the death of the annuitant. Whilst this gave guarantees of income throughout a lifetime, this arrangement was not suitable for everybody.
The pension freedoms have removed the limitations set on income drawdown arrangements that have gradually become more mainstream. Phased retirement has been available on personal schemes for many years and this has gradually loosened into the income drawdown that we now know. Income from drawdown was limited to figures provided by the Government Actuaries Department (GAD) and were largely in line with annuity rates, although slightly higher. Drawdown was viewed as higher risk as it did not have the guarantee of the income level offered by traditional annuities.
Within DB schemes, the benefits are payable at the scheme Normal Retirement Date (NRD), with reductions made for early retirement and possibly some enhancement for delaying taking benefits after the NRD. Anybody that did not fit the scheme plan was disadvantaged.
Originally, Defined Benefit schemes were not included in the pension freedoms environment. However, the rules around this were amended to enable transfers to be undertaken.
Shape of benefits in retirement
Nowadays, as more people work flexibly, they want to take their benefits with similar flexibility. They may not wish to take the full initial lump sum. Or they may still continue working, or run down their business and look to take varying levels of income from their fund.
As well as offering variable and flexibility in income, personal pension plans now also present an estate planning opportunity as funds can be passed on after death to a spouse, children or grand-children. For people suffering ill-health, this is an attraction to transferring out of DB scheme, where the benefits would be halved or even totally lost on death.
It is this change of shape of benefits, made available within more plans as providers have moved with customer demand, that has made the move out of DB schemes more attractive. It has led away from the slavish dependence on TVAS calculation to govern whether transfers are considered to be suitable advice. TVAs calculators are still providing the figures, but those figures are only truly relevant if considering identical benefits to those available within the DB scheme.
Advisers need to make sure that when considering any kind of transfer out of a DB scheme that the benefits of that scheme are made clear to the client. The exact terms of the benefits should be set out to see the income that would be paid and possibly calculate the total value of the payments up to a certain age – 85/90 or whatever the average life expectancy is at that time.
DB scheme administration issues
Any moves to build in flexibility to DB schemes would suffer from similar issues of delivery. Partial encashments would be very difficult to administer and would cause the trustees and administrators huge issues.
Due to the fact that many DB schemes are either shutting or not allowing new members, there will not be the continuous turnover of membership or the volume of contributions that the schemes used to receive. Therefore, most schemes are in the throes of decumulation.
To build in flexibility of benefits in DB schemes at this time of running schemes down would need to be handled with great care. As the schemes contract, with members leaving or retiring, great care needs to be taken to ensure that there is sufficient value maintained in the schemes for the members that have not yet reached retirement age. The calculations for flexible benefits could lead to distortion of the value of the benefits for individuals remaining in the scheme.
It should be remembered that these transfers can only be undertaken by advisers within firms that have the FCA permission. They are still considered to be high risk by the FCA and detailed consideration of the suitability to the client for each case needs to be carefully recorded. The fact that pension freedoms have increased the attractiveness of leaving schemes at the same time as record low gilt yield rates have made it easier to exhibit suitability.
Advisers still need to be cautious in practising in this area as the short term gains and flexibility may be found to be as damaging and toxic as other ill-conceived ideas, such as mortgage endowments, split capital investment trusts and UCIS investment. A defence that it seemed like a good idea at the time may not save the advisers in the future.
About Tony Catt
Tony is a freelance compliance consultant who undertakes a whole range of compliance duties for his IFA and restricted adviser clients. He was previously an adviser with a directly affiliated firm, which helps with his current compliance duties.
Email – email@example.com
Phone – 07899 847338.