PensionsSep 24 2014

A rush of DB to DC transfers?

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One question that must be on the lips of every pension adviser is whether the new rules that are to kick off in April next year will trigger a rush of transfers from defined benefit (DB) to defined contribution (DC) schemes. It is a question that is also on the minds of companies sponsoring DB schemes.

As has been well documented in the press, under the pension reforms due to start at the beginning of the next tax year, pensioners will be able to take their pot as a single lump sum or take healthy levels of income from a drawdown regime.

In order to guard against the scenario in which members in an attractive DB scheme transfer out in order to access their funds immediately – significantly reducing their retirement income by doing so – the government at first considered an outright transfer ban. But the authorities have since relented, and now the plan is that DB to DC transfers will come with mandated advice – advice that individuals must take but may choose to ignore.

On top of this, the qualifications required to advise on transfers from occupational DC schemes to drawdown arrangements may be relaxed in order to provide greater public access to advice.

A combined effect of these initiatives could be a rush of requests for transfers by individuals, and encouragement by sponsoring employers for them to do so. It should also mean more work for pension specialists and some have already reported a significant increase in enquiries in advance of the rule changes. So is the market for pension transfers about to take off?

Breaking the golden rule

DB pensions are talked about in hushed tones among workers old enough to have heard of such things and are generally considered to be as rare and valuable as gold dust. For years, the received wisdom among regulators and pensions experts was that it is rarely in the best interests of DB members to transfer out. That principle has led to an unusually heavy handed regulation of pension transfer advice and the transfer values that schemes offer their members.

The art of pensions transfer advice is relatively arcane – mostly because, for many reasons, it is notoriously difficult to engineer a positive recommendation. For instance, it is not in the interests of pension schemes to provide attractive transfer values for their members. Generally speaking, transfer values are set by the trustees at a level such that they would improve the funding position of a scheme, rather than worsen it. When calculating the value of a member’s pension as far as the overall scheme is concerned, the trustees may assume that investments grow at a conservative 4.5 per cent a year. But when calculating the cash equivalent transfer value (CETV), a ‘best estimate’ assumption of 6 per cent a year might be used – significantly reducing the lump sum.

The margin between the two is designed to protect the scheme, but it is hard for individuals to make up the difference, particularly when the typical bells and whistles that come with a DB scheme are taken into account: inflation linkage, death benefits, spousal pension,

etc.. When all this is calculated the investment return needed to closely match the defined benefits – known as the ‘critical yield’ – is normally too high for the transfer to be recommended.

Exceptions make the rule

Despite this, there tend to be three scenarios in which transfers go through.

1. Companies which are keen to reduce the size of their pension funds – often seen as a risk and a barrier to business growth – have sidestepped the critical yield problem by enhancing the CETV to the level needed to achieve a transfer recommendation by an IFA. Through the companies own modelling, a level is calculated which leaves the scheme no worse off, the member fending for themselves with a larger transfer and the company with a smaller scheme around its neck. There was a rush of enhanced transfers a few years ago but take-up among members was often not as high as expected. Companies also found that the ‘wrong’ members tended to take them up – ie, those with relatively small pensions, not the smaller number of very large pensions that represent a much larger risk to the scheme.

2. In some cases, individuals who do not require the bells and whistles of their company scheme (such as spouse’s or dependent’s pension if there are none) and those with severe health issues may find that the maths work in their favour. This is particularly the case for those who qualify for an impaired annuity, at attractive rates, and who may have a lower life expectancy than is typically assumed by the pension scheme’s actuary. In this case the transfer could make a real difference to retirement income.

3. Despite a recommendation against a transfer, many still decide to do it anyway.

Under the new regime, the lure of instant access to pots that can be extremely large even after the CETV calculation may well prove too much for some pensioners. The typical CETV calculation is less punitive for older members (as the difference between the scheme’s conservative assumptions and their best estimate has a shorter period to play out) and that can mean even without a company enhancement the transfer quote is more likely to pass the test for a recommendation near retirement.

More likely, perhaps, is a raft of the third scenario – members transferring out even after being advised against it. That is what some in government feared, which is why an outright ban was being considered at one stage.

Fancy becoming a transfer specialist?

While the requirements for recommending an occupational DC to personal DC may reduce, the DB to DC market is set to continue to be as tightly regulated as ever. The Box highlights what is entailed (pension transfer requirements).

Service providers exist which can take away the legwork from producing a transfer report, but there is no avoiding the examinations.

Advisers eyeing up the potential transfer market must consider that without a company enhancement, they will find it difficult to recommend a transfer even when the individual is dead set on it. That does not mean this is not going to be an attractive market for advisers – but it is one the government and regulators will be keeping an extremely close eye on.