Calculating pension transfer values

Transfer values are the sums paid from a pension scheme when a member chooses to withdraw their entitlement. They can be paid from defined contribution (DC) or defined benefit (also called DB or final salary) schemes.

Transfer values paid from DB schemes are the only ones that require assumptions about the future, which is always uncertain. Also, due to the pooling of risk between members, the level of transfer payment can also affect other people’s entitlements. It is therefore crucial that the level of TV payment is fair to all.

In the past lethargy and lack of knowledge led many people to leave pensions in previous employers’ schemes until they came to retirement. Some forget that they have entitlements until schemes contact them – assuming that the administrators have been informed of changes of address and so can find members who left jobs many years previously. 

Members transfer for many reasons. They might feel safer with an insurance policy in their own name – in case anything happened to the scheme – or perhaps they prefer to keep all their pensions in one place. It also allows defined benefit members to shape their pension to suit their own needs, where these differ from those in the scheme’s rules, for example by:

•    Taking their pension earlier or later than the scheme rules offer.

•    Allowing for different levels of inflation protection.

•    Altering the level of dependents’ pensions to provide more or less for a spouse, or to remove them completely if they have no dependents.

Pension freedoms introduced in 2015 changed this in a big way, encouraging more members to transfer. Since 2015 holders of defined contribution plans:

•    Do not have to buy an annuity.

•    Can draw their pension more flexibly.

•    Can even take the whole pot as cash – although this would be subject to tax.

These freedoms only apply to members of DC schemes, so if DB scheme members wish to take advantage of the flexibilities, they have to transfer. Publicity over the new legislation seems to have energised people into thinking about their pension and taking action, which must be positive.

Similarly, over the past several years, more and more DB schemes have closed and sought to reduce the risk inherent in their arrangements. One way to de-risk is to reduce the number of members and the size of the scheme’s liabilities, which means the members who transfer out are helping the de-risking process.

This has led some schemes to offer incentives – by increasing transfer values – as an inducement to leave. Consequently, DB schemes have found the number of members transferring out has increased. It remains to be seen if this trend will continue.

The level of a transfer value from a DB scheme is not specified in the scheme’s rules, unlike other benefits. It is instead an option members can choose. The terms used are set by the trustees – on the advice of their scheme actuary – at the time of the transaction.

The scheme actuary’s aim is to calculate the “best estimate” of the amount needed to buy the equivalent to the scheme entitlement. The actuary has to tread a careful line to be fair to both sides, ensuring any transferring member and those remaining in the scheme are not left worse off.

Transfer values are usually less than the amount the scheme aims to hold for the member as they exclude any additional margins for smoothing out adverse experience. This means members transferring out usually create bigger margins for the remaining members. Stayers would still only receive their entitlement under the rules, but the scheme’s assets are more likely to be sufficient to pay them and employers are less likely to have to increase their contributions.

However, if the scheme is underfunded, paying out a full transfer value could mean remaining members are left worse off. Underfunded schemes – those with a poor outlook for returning to full funding – may reduce transfer values (an “actuarial reduction”) so as not to disadvantage those left behind even further.

Because the market value of the scheme’s assets – from which the transfer value would be paid – changes frequently, technically transfer values should also change frequently to make sure leaving members are not given too little or too much.

Depending on the scheme’s systems and processes, transfer value calculations can be updated anything from daily, monthly, quarterly or perhaps only when key indicators (for example, interest rates or equity market levels) move outside a certain range. As market conditions can change considerably over days or weeks, let alone months, any delay in updating transfer terms could have a significant impact on transfer values for members and their schemes.

Schemes also have to guarantee their transfer value quotations for a period of at least three months to give members time to make arrangements with an insurer. Therefore, by the time a payment comes to be made it may no longer be the appropriate amount, with the scheme either paying too much if terms have worsened or vice versa. In some cases, schemes will offer the member the better of the original terms or those at the time of payment.

The impact is likely to be slight for an individual member with a modest entitlement. However, when members with larger entitlements transfer or there are groups of transfers – as in recent times following pension freedoms and scheme de-risking – transfer values can have an impact on the scheme: both on funding and liquidity levels.

Transfer value calculations require assumptions about discount rates, inflation rates and demographic assumptions, all of which apply many years into the future and so there is considerable uncertainty over how these factors will play out. 

Discount rates are often based on long-dated bonds adjusted for the scheme’s actual asset mix. Currently gilt yields are at low levels, which results in lower discount rates and higher transfer values. At the same time, the long-term inflation rate outlook has risen, which also tends to increase transfer values in many DB schemes.

These higher transfer values attract more members to transfer out as they might expect that such a relatively high transfer values can be invested to provide a higher return and greater pension than the more prudent assumptions used by the scheme actuary.

The green line on the chart shows that gilt yields have fallen since the start of 2016 and the trend looks set to continue.

The other lines show the approximate cost of £1,000 a year pension for a 65-year-old with no dependents, valued on the same discount rates as the green line, to give a rough indication of the relationship between bond yields and transfer values. The orange line shows pensions with no annual increases and the purple line shows inflation linked increases.

There was a large fall in gilt yields over the period just after the Brexit vote. Although the fall reversed towards the end of 2016, it looks to be slowly falling again in 2017. Transfer values are likely to have followed an inverse path depending on the scheme’s rules.

This simple analysis suggests people requesting transfer values last autumn are likely to have done well. Experience suggests they may also have told their friends and colleagues about the size of their transfer values, encouraging more people to consider transferring.

Setting transfer values is a challenge to balance practical requirements against the needs of fairness – for the ongoing scheme as well as the transferees. It is equally challenging to assess whether someone taking a transfer value will be better or worse off in the future.

Tim Bateman is life actuarial partner and Katie Dawson is senior pension consultant at Mazars

Key points

Pension freedoms have encouraged more members to transfer.

The scheme actuary’s aim is to calculate the “best estimate” of the amount needed.

CETV calculations can be updated daily, monthly or quarterly.