There has been a huge amount of what I can only describe as ‘hype’ in the popular press and financial magazines over recent months, almost wholly negative, about the practice of employers topping up final salary scheme transfer values to allow members to exercise a real choice in relation to their pension benefits. I wouldn’t wish to suggest that reporting on this matter approaches the worst excesses of the fourth estate (“Freddie Starr ate my Hamster” or “London bus found on Moon” for example) but headlines such as “Bribes offered to quit final salary schemes”1 and “Regulator launches probe into growing ‘cash for company pensions’ scandal”2 certainly leave scope for a more considered and balanced assessment of the issues.
Whilst I have no doubt that as in all areas of life and business some people will attempt to circumvent rules and practices to arrive at a result which has been achieved ‘on the cheap’ it is disingenuous to take this minority as representative of the whole. There may indeed have been some employers who have tried to provide staff with ’bribes’ to encourage them to leave their final salary scheme and this would indeed be a “scandal.” If this has been the case, no doubt they will over time be identified and made to compensate staff for their actions, however, focussing on this minority only serves to obscure the bigger picture. I find it hard to believe that against the rigorous regulatory background imposed around pension transfers in the mid 90’s that either financial advisers would recommend or insurers would accept transfer values which were patently not in the members’ best interests, having taken account of their specific personal circumstances.
If we take this back to its basic constituents I believe that there are 2 fundamental issues. Firstly that any financial package offered represents reasonable value for money to the individual based upon the benefits held in the final salary scheme. Secondly, that individuals are placed in a position to make an informed decision about their options via the provision of quality independent financial advice funded by the employer.
Looking at each of these issues in turn, firstly members have a statutory right to receive a transfer value. That transfer value is only one of a number of options open to members in terms of retirement planning. Most importantly members cannot be forced to take a transfer value.
- Clearly members should only consider taking the transfer value if it offers realistic value, relative to the benefits being foregone in the final salary pension scheme. Given the level of underfunding prevalent in most final salary schemes and the commensurate cut back of transfer values to reflect this, in recent years the financial equation hasn’t been right for members and as such very few transfers have taken place.
Over recent years the true cost of pension benefits has become more apparent to employers via disclosure in company accounts under FRS17. This has caused many employers to seek ways of managing their pension liabilities more pro-actively than in the past. Companies have concluded that it may be in their interests to offer people genuine choice with regard to their benefits built up in pension schemes. To do this they need to offer transfer values which properly reflect the underlying benefit. The way to achieve this is to top up the transfer values that can be supported by the scheme to the fair value level.
Offering people choice carries risks – people need to understand the implications of each of the choices available to them. In order for members to consider if a transfer value and top up represents a realistic equivalent to the value offered by the scheme quality independent financial advice is required. Left to their own devices people will not seek advice if they perceive there is a cost to them in obtaining it. However it is also in the employers’ interests that any choices made by members can be demonstrated to be informed choices and this is a powerful incentive for companies to meet the cost of that advice.
Very few financial advisers are authorised to provide this very specialist type of financial advice and they require to be highly trained and to meet very rigid regulatory requirements when exploring these options with members.
They must consider what level of return any transfer value would need to achieve, based upon assumptions set by regulation, to match the benefits being provided by the scheme. This level of return is known as the ‘critical yield.’ It would only be if this yield met the IFA’s strict advisory requirements that it would be likely that any consideration of a transfer option would even be able to proceed to stage 2. This means that employers would need to top up transfer values to a level where this critical yield hurdle was met. This financial top-up and the provision of advice is seldom a ‘cheap option.’
If the critical yield hurdle rate has been achieved the adviser will need to then make a thorough comparison of all other financial and personal issues relevant to the member before being able to progress to a recommendation. These issues would include such things as the level of tax free cash lump sum, the benefits applicable on death and the early retirement flexibility available under both the existing scheme and any transfer vehicle considered.
These are all highly complex comparisons which will vary between each member. Some examples where a transfer may be worthy of further consideration might be where the scheme member is single and the scheme provides spouses’ benefits from which they will not benefit or where the individual is in ill health and impaired annuity rates would provide for a higher pension or where a greater amount of tax free lump sum death benefits might be available.
There are additionally taxation and state benefit considerations all of which need to be included in the research and recommendation. For example, particularly for lower earners, the impact of taking benefits in a certain format on the amount of tax paid or the state benefits received needs to be considered. In certain identifiable circumstances the provision of a pension outside the scheme or indeed a cash payment may improve the overall financial position of the individual.
It is also worth noting that many scheme members who have left the scheme sponsor’s employment may welcome the chance to take benefits to an arrangement away from that employer.
It is reasonable to assume that anything that falls outside these two key criteria is likely to be open to challenge now or at some point in the future. If employers attempt to offload liabilities using poor value transfers or without providing access to independent financial advice to ensure that members are in a position to make an informed choice, then the criticism seen to date may well be justified. Where members are given fair transfer values and access to high quality independent financial advice there is little reason why employers, trustees, individual members or even the Pensions Regulator would have concerns about the process. The potential for a win/win situation is significant.
We believe there needs to be a rational debate as to how companies who wish to better manage their final salary liabilities engage with their current and former employees. Guidance for companies and trustees in this area would be very welcome and we would encourage the Pensions Regulator to consider issuing a Code of Practice in this area in accordance with its powers under the Pensions Act 2004.
Finally, our legal advisers have asked that I make it clear that I don’t believe Freddie Starr has eaten anyone’s pension – but I never believed he ate the hamster either.
1 Sunday Times 7 May 2006
2 Scotland on Sunday 17 September 2006
David Davison is a Director at Spence & Partners, independent actuaries and consultants.