Defined BenefitMay 4 2017

Reducing risk of complaints

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Reducing risk of complaints

There is no doubt that the introduction of pension freedoms by former chancellor George Osborne has created a sea change in the level of demand for final salary pension transfers. The question is whether this should be something to celebrate or a cause for concern. 

In its recent guidance note the FCA specifically made the point that assessing transfers based solely on critical yield does not meet regulatory expectations. Critical yield is, of course, an important factor, but just one of many. In practice it always comes down to the individual. Any bland assumption that giving up the security of a fixed pension for life is automatically a bad thing misses the point and could breach the requirement for "treating customers fairly".

People's needs and objectives, as well as their financial circumstances, can vary widely. It may be a bad thing for a lot of people, but for others it will be a good thing. 

Although someone with a cautious attitude to risk is unlikely to be a suitable candidate for transfer there are even exceptions to that, for example where the key objective is to improve the benefits for their beneficiaries. This would be particularly relevant where the member is in poor health, with a limited life expectancy. Most schemes only provide 50 per cent of the member’s pension on premature death, which represents a major loss of value to the survivor.

The size of the transfer value may also be irrelevant. Someone with a modest final salary benefit, relative to their overall wealth, might well be better to transfer even if the transfer offered does not represent great value for money (as measured by the critical yield). 

For larger cases with wealthy customers, death benefits are also often the key issue due to the change in the tax treatment of pension death benefits. There are situations where transferring to a personal pension with a view to growing the fund to pass down to family on a second death can form a vital part of a wider estate planning strategy. In effect clients can have two estates, their personal estate and their pension estate and it may be more tax efficient to spend down their personal estate consisting of cash and investments and preserve their pension estate if there is a prospective inheritance tax (IHT) liability.

Drawing down more from other capital resources will also save income tax and preserve a higher proportion of their overall assets in a tax-exempt environment, while also reducing their taxable estate and IHT exposure. For many well-off retirees, the idea of passing down pension pots to children or grandchildren is often attractive as their heirs are unlikely to have such valuable pension rights themselves. 

In other cases the flexibility to vary the pension income level in retirement is more important than a secure fixed pension. This may be relating to income tax planning or simply cash flow management, for example someone whose pattern of expenditure requires a higher income for a period of years, such as the need to meet ongoing education costs for children, or to supplement variable ongoing earnings. 

Nevertheless, pension drawdown is usually a relatively high-risk strategy and advisers should always assess the client’s capacity for loss. If their financial needs in retirement are less than the income that would emanate from their private and state pensions they will have a higher capacity for loss. Equally, if they have surplus personal capital reserves that could be called upon if required to make up any shortfall as a result of a fall in the value of the fund, that would also indicate a higher capacity for loss. 

Retirement modelling systems that can simulate a stock market crash are helpful in assessing capacity for loss. Typically I will look at a scenario where the equity element of the recommended strategy falls by 30 per cent, with no market recovery. That is a harsh test indeed, as stock market crashes are invariably followed by some recovery.

By benchmarking the client’s long-term needs against market annuity rates for a joint life index linked annuity, assuming the drawdown fund were switched to an annuity at 75, it is possible to assess whether the client can withstand such a financial shock.

This brings me onto the financial assumptions for assessing the suitability of a defined benefit transfer. In its recent guidance document, the FCA highlighted the need for advisers to consider the likely expected returns of the assets in which the client’s funds will be invested, relative to the critical yield. 

The underlying assumption about the future growth rate will be based primarily on the proposed asset allocation, which would vary significantly depending on whether the proposed investment strategy is on an assumption of the pension being secured under an annuity at retirement or, alternatively, pension drawdown. A short-term strategy for the period to retirement would be totally different to a long-term drawdown investment strategy and in most cases two sets of assumptions will be needed.

The implied risk and return should also take into account the client’s risk appetite, as well as the client’s dependency level on the pension, taking into consideration their other assets and income resources including those of their spouse or partner where appropriate. The assumptions used in the transfer analysis should always reflect the proposed asset allocation. Any material variation could invalidate the advice.

Lastly, the tricky matter of insistent customers. While it is clear that advisers are permitted to facilitate insistent customer transfers, and the FCA has laid down three key steps that must be taken, my own view is that this is potentially dangerous. In such cases I take the view that either the client has misunderstood my advice, or I have misunderstood the client. This approach leads to an extended dialogue where the client is asked to explain in writing their reasons for still wanting to transfer in spite of my advice to the contrary. 

This appeals process generally works well and I believe it better meets the principle for treating customers fairly. Where I still do not consider a transfer to be suitable, I address each of the client’s submission points explaining specifically and clearly the reasons why they do not alter my previous recommendation. This is almost always accepted by the client. 

In other cases, it may be that a client had originally misinterpreted the meaning of a particular question on initial information gathering forms, or omitted a relevant piece of information, and I am able to reverse my previous advice in favour of transfer. 

One major advantage of this approach is that it significantly reduces the risk of a complaint down the road, on the premise that either the client did not fully understand the advice or the adviser did not adequately know their customer.

Complaints could still arise where the advice was against transfer if that advice was unsuitable and a loss arises, for example in the event of premature death. Many firms have chosen to outsource this type of business and demand is likely to remain strong. 

The FCA is continuing to review the market and no doubt will provide further guidance as appropriate. 

Steve Patterson is managing director of Intelligent Pensions

 

Key points

Any assumption that giving up the security of a fixed pension for life is automatically a bad thing misses the point.

For larger cases with wealthy customers, death benefits are also often the key issue.

The implied risk and return should also take into account the client’s risk appetite.