Defined benefit pension scheme transfers
Liam Mayne explains why transfers from defined benefit pension schemes are more popular than ever and what that means for individuals, employers and independent financial advisers
Hands up who would like a guaranteed income for the rest of their life paid for (mostly) by your employer? Who would like this to increase (broadly) in line with inflation every year? And who would like their spouse or partner to carry on receiving (a proportion of) the income after you pass away? I’m guessing quite a few of you.
That is the promise that 11 million members of the UK’s 5,800 private sector final salary, or defined benefit (DB), pension schemes have, to a greater or lesser extent. It includes 5.1 million deferred members, who left their scheme but have not yet started receiving the pension they have built up, who are the focus of this article.
The law has always provided these deferred members with a right to transfer out their DB pension to another pension scheme – swapping a guaranteed income for life for a cash sum. But, generally, taking a transfer just meant investing this cash sum in a defined contribution (DC) pension scheme, with all the risk that entailed, and then buying an expensive annuity at the end of it. This gave a lower guaranteed income than had they simply stayed in the DB scheme in the first place. So, transfers out of DB pension schemes were very few and far between.
The ‘Freedom and Choice’ changes that came into effect in 2015 changed that logic. It has had profound implications for deferred members of DB schemes, for the employers sponsoring these DB schemes and for independent financial advisers (IFAs) who provide (the now legally required) advice on DB to DC pension transfers.
Let’s start with members. Freedom and Choice means that money in a DC scheme can be taken flexibly as soon as the member reaches age 55 – either all at once as a cash lump sum, drawn down in regular instalments or anything in-between. This type of flexibility is not available in DB schemes. This provides members with a much stronger incentive to transfer out their DB pension than existed before.
The Pensions Regulator (tPR) and the Financial Conduct Authority (FCA) are naturally cautious about the merits of transferring DB pension benefits. Their view is that individuals, and their IFAs, should start from the premise that such a transfer is not in their best interest.
But for employers, there is a different side to the story.
It is well-publicised that the costs associated with DB schemes have risen dramatically in recent years. According to data published by the Pension Protection Fund (PPF – the industry lifeboat scheme), the average pension scheme in 2006 had ‘PPF liabilities’ of £100 million. That increased to over £250 million in 2016. Over just 16 months since the end of 2015, my firm estimates that the aggregate DB pension liabilities to be disclosed in the accounts of companies in the FTSE 350 has increased by 28 per cent, or just over £180 billion. And hardly a week seems to go by without an example of another company struggling under the weight of their DB pension scheme costs.
Why? Primarily, this is a consequence of a decade of low interest rates. This has pushed up the price of the safe, income-bearing bonds that many pension schemes plan to buy in future, to match the pensions they have promised to pay. But members of DB pension schemes, like the wider UK population, are also expected to live a lot longer than when these schemes were set up – which makes paying a pension for life more expensive too. Latest estimates show that a 65-year-old man today is expected to live for another 22 years, and for a woman it is 24 years.
Naturally, employers are looking for ways to control these costs. Having largely closed their scheme to new employees, and then stopped the build-up of new benefits for current employees, they are turning their attention to the 5.1 million deferred members.
For an employer, whenever a deferred member takes a transfer value from their DB scheme, the cost of providing the benefits to that individual are crystallised and settled immediately – there is no future uncertainty. In addition, the law allows transfer values to be set at a level below the prudent reserve they are required to hold if the member stayed in the scheme. So, by members taking a transfer value, they can be reducing both the amount of funding and ongoing risk to the employer.
From the member’s perspective, for the same reason that the pension scheme liabilities have increased so sharply in recent years, transfer values being offered are also at record high levels. Whilst they do vary from scheme to scheme, transfer values of anywhere between 20 to 40 times the annual income that the member would otherwise receive are not uncommon.
It is worth taking stock of the potential numbers at play here. DB pension schemes are currently sitting on assets totalling £1,300 billion. Crudely assigning 45 per cent to the 5.1 million deferred members (out of 11 million in total) suggests DB schemes may be holding £585 billion in respect of them. Assuming the bulk of them will reach retirement age over the next 20 years, and that anywhere from 10 per cent to 30 per cent might transfer out, suggests a potential flow of transfers of £3 billion to £9 billion a year across perhaps 25,000 to 75,000 individuals annually.
Given the perfect storm of the new flexibilities in DC schemes, record high transfer values and employers looking to mitigate their costs, many pension schemes are now routinely offering transfer values to deferred members. For employers, this has become a well-recognised risk management option and the flow of transfers out of DB schemes looks set only to increase.
However, the group perhaps most impacted by all of this is the IFAs. In conjunction with the 2015 changes, the government, recognising the potentially detrimental decisions members might make, made it a legal requirement that DB members take financial advice before being allowed to take a transfer value of £30,000 or more. Consequently, the demand for pension transfer advice – a relatively specialised area – has exploded.
Increasingly, employers are prepared to cover the cost of the advice, or in some cases are legally required to. As a result, IFAs are partnering with employers and their pension schemes to provide a smooth and efficient process for deferred members wanting to consider their options. Just as the savings for employers are considerable, so is the potential market – and associated liability – for IFAs. Based on the numbers above, the advice market could be anywhere from 50,000 to 150,000 individuals a year, or more.
As past pension mis-selling episodes have proven, the potential for exposure to bad practice in this area should not be underestimated. Insurers providing Professional Indemnity cover for IFAs will no doubt be taking a closer look at the level of pension transfer advice being given. It is also notable that this year the FCA is consulting on increasing the level of redress an individual is entitled to where they receive poor pension transfer advice.
For members, employers, their pension schemes and IFAs, it is a land of opportunity, but one that should definitely be approached with the appropriate degree of caution.
Clearly with this value of funds in play there are significant risks. Insurers are very concerned that transfers which are not well managed could give rise to claims in the future.
The FCA provided a practice guidance note on 24 January 2017 which detailed their expectations of how these transfers should be handled. The Pensions Regulator advised in May, following a Freedom of Information request, that 67,700 people transferred out of defined benefit schemes in the year to 31st March 2017. The FCA has been investigating firms’ approach to defined benefit transfers with a number of firms having had their permissions removed.
We would countenance significant caution from advisers undertaking work in this area. First, ensure your Insurer is aware that this work is something that you do and be very clear about what you don’t do. Document very clearly why this is suitable for the client (and in detail) so that if the client spends their funds unwisely and run out of money that they cannot pursue you for not pointing out the risks of swapping a guaranteed annual income for a significant amount of upfront cash.
We spend a lot of time discussing this issue with various parties (clients, Insurers and solicitors) and we see best practice in this area as an evolving process and we will look to keep our clients involved as this develops.