Article: Adopting a Carrot and Stick Approach | Publication: FT Advsier| Date: 16 June 2011 | Author: David Trenner
Enhanced value transfers and account deficits paved the way for incentivising scheme members to opt out
Recently pensions minister Steve Webb has attracted publicity by telling everyone that transfer incentives are invariably bad for members. He said: “People do not understand what they are doing and in many cases are making the wrong choice.”
What he says is nothing new. In July 2010 a joint statement from the FSA and The Pensions Regulator said: “The regulator believes that trustees should start from the presumption that these exercises are not in the members’ interest.”
But is it as simple as that? If an employer offers you money to transfer your pension, is he in effect bribing you with money up front to take up a poor retirement deal? Or could it be that enhanced transfer values offer win-win situation for employer and pension scheme member?
Enhanced transfer values came to prominence in the mid-2000s. Employers were faced with financial reporting standard 17 issued by the Accounting Standards Board which required disclosure of pension scheme deficits in company accounts for periods starting after 1 January 2005. To make matters worse, FRS17 required growth assumptions based on bond yields even where the scheme was largely invested in equities. This meant that a scheme which had been regarded as fully funded could show a significant deficit in the company accounts.
Many pension schemes had been running for a number of years and, as a result of the introduction of ‘preservation’ it was not unusual for a scheme to have more deferred members than it did current employees. Preservation came into effect in 1980 when anyone with five years in the scheme had to be given a deferred pension. From 1988 the minimum service was reduced to two years. So companies were faced with substantial pension scheme deficits, a large part of which related to people who had not worked for them for many years.
To compound the problem, buying out these liabilities with an insurance company would cost even more than the FRS17 value as guarantees are expensive and insurance companies need to earn profits for their shareholders. And so the idea of incentivising former members to transfer away was born.
Before January 2007, HM Revenue & Customs received legal advice that any cash payment to a pension scheme member to encourage them to transfer their pension would be free of tax and national insurance. So a cash payment could be offered to the member. He might even be told that if he was concerned at the loss of pension rights he could contribute this sum back into a new pension arrangement and benefit from tax relief.
This might have assuaged the guilty consciences of some trustees, but I am not aware of many who reinvested. Far more common were those like the woman I spoke to. I explained that we would charge a fee for advice and we might not recommend that she transferred. Her response? She said: “But I have already ordered the new kitchen”.
There is no question that some of the early offers to members relied on the idea that cash in the hand was more highly regarded by most people than a pension you might not live to receive. A large retail group offered comparatively small lump-sums to 11,000 former members and by all accounts the take up was good. Some employers with underfunded schemes offered to make a cash payment equal to the reduction in the transfer value, which could hardly be described as generous.
In January 2007 the HMRC announced that it had received new advice and that henceforth any cash payments would be subject to tax and national insurance. Simultaneously The Pensions Regulator issued guidance for trustees in which they highlighted that transferring might not be in a member’s best interest. The Pensions Regulator has regularly updated its guidance, and experience indicates that enhanced transfer values offers are becoming fairer.
So how can an enhanced transfer values offer be win/win for both employer and pension scheme member?
Suppose a pension scheme member aged 40 has a deferred pension of £5,000 a year. This can be expected to rise in deferment up to age 65 to about £10,000 a year, assuming inflation averaging about 3 per cent a year. The pension at 65 will cost the scheme about £240,000, should it choose to secure it through an annuity. So assuming that it can achieve a yield of about 7 per cent a year in the next 25 years, the scheme needs to have about £45,000 in reserve to meet this liability. This should be broadly equal to the transfer value, subject to various technical adjustments.
Now the member might have all sorts of reasons for transferring but the best reason is to get a bigger pension. Unfortunately by the time he adds the effect of expenses of 1.5 per cent to 2 per cent a year, he will need a return on the reinvested transfer value approaching 9 per cent a year to achieve this. Unless he has a very aggressive attitude towards investment risk, or he is more concerned about other factors such as death benefits, he is not going to transfer.
But what is the FRS17 liability? Assuming bond yields of about 5 per cent a year this will be about £70,000. So if the scheme is holding £45,000 it will have a £25,000 deficit. Could that liability be secured with an insurer? Assuming guaranteed returns of about 3 per cent year, the scheme will be charged about £110,000.
From the employer’s point of view paying an additional amount of up to £25,000 will actually improve its position as reflected in the accounts, particularly if it is making profits and can claim corporation tax relief. Even enhancing the transfer value up to, say, £80,000 will save £30,000 if it wants to wind up the scheme and secure benefits with an insurer.
Suppose the employer offers an extra £20,000 on the transfer value, taking it to £65,000. The member will require a return on the reinvested value of about 7 per cent a year to improve his pension at 65. He may very well feel that this is achievable. If other considerations, such as flexible income and better death benefits are a consideration, then there is every chance that he will decide to transfer.
So the member transfers £65,000 out of the scheme with every chance of improving his pension. If he does not have a qualifying dependent he will almost certainly improve his death benefits and he will take control of the fund, which might appeal to him. At the same time the employer pays £20,000 into the scheme to reduce his FRS17 deficit by £25,000. This certainly looks like win/win to me.
Of course the member might have a cautious attitude to risk and be happy with a predetermined pension over which he has no control. He might not have a concern about death benefits or controlling his fund. In this case he should not transfer his benefits and it is hugely important that he has access to impartial financial advice – preferably paid for by the employer – to enable him to understand this.
There is no doubt that however generous the enhanced transfer values offer there will be members who will be best not to transfer, and Mr Webb is right to be concerned that these members are properly protected. He is also right to be concerned in the few remaining cases where the enhanced transfer value is not generous, or where the employer appears to be putting pressure on members to transfer.
But notwithstanding these concerns he should understand that enhanced transfer values can be attractive to both members and employers. We, as financial advisers, should appreciate the need that members will have for advice which is independent of the employer and meets their personal financial objectives.
Contact David to discuss any of his comments from this article
