There’s been a lot of press comment recently about companies offering staff what have been called ‘sweeteners’ to give up all or part of the final salary promise from their pension scheme.
Given the extent of the final salary pension problem, its potential impact on business and the likely timescale over which scheme deficits now need to be addressed I think that it’s hardly surprising that companies are seeking solutions which help them to manage their final salary liabilities more proactively.
There are concerns however that, as a result, members are foregoing benefits without fully understanding the consequences and that employers are effectively discharging liabilities ‘on the cheap’. So is this always the case?
It is important firstly to note that individual scheme members have a statutory right to a transfer value from their scheme at any time. Given the mis-selling scandal of the early 90’s providers will now only accept a transfer payment on the assurance that the transferring individual has been properly advised in relation to the transaction. Equally the same scandal has ensured that only a very foolish Independent Financial Adviser (“IFA”) will do anything other than make a recommendation to a member which can be demonstrated to be in the member’s best interests when based upon their specific circumstances.
In recent years relatively few individuals with deferred final salary scheme benefits have been able to genuinely consider this option as the transfer value provided would in all likelihood be reduced to reflect the funding position of the scheme, and the majority of final salary schemes are currently running deficits on any sensible measure of their liabilities. Given this the individual would be highly unlikely to transfer and indeed any financial adviser involved would be likely to expressly recommend that the individual retained their benefits in the scheme.
Interestingly throughout the last decade we have witnessed a significant decline in the number of scheme members accepting transfer values from final salary schemes which would support our comments above and suggest that the values offered do not fairly reflect the value of the benefits given up.
There is clearly a balance to be struck where the level of transfer value that employers are prepared to pay is equal to that which employees are prepared to accept and where this is achieved a win-win scenario is possible.
Part of the pensions debate in the UK has been to get companies to place a realistic measure on their liabilities for funding purposes. Despite its flaws, a consensus appears to be forming that, a measure akin to FRS17 is a reasonable basis for an employer to seek to fund and it seems not unreasonable that transfer values should also reflect this new consensus.
Where companies are ‘topping up’ the transfer values offered to a level which fairly reflects a realistic assessment of the value of an individuals benefits in a final salary scheme this tends to make the financial pros and cons of transferring more neutral. It’s difficult to see how ensuring members are offered transfer values which fairly reflect their entitlement can be viewed as a negative development.
In addition, providing the concept of fair value is maintained, the individual could be offered either a top up directly to their pension scheme or a monetary compensation payment. In circumstances where this compensation payment receives favourable tax treatment or is even treated as tax exempt this can, if the individual so decides, be used to further enhance retirement benefits, as re-investing this amount will entitle the individual to additional tax relief on the contribution.
So it could be said that what we are seeing is a transfer value basis being agreed and offered which more fairly reflects, in many cases for the first time, the value of member’s benefits in final salary schemes. In turn this means that members are presented with a genuine choice about how they manage their pension benefits for their retirement. Many schemes, for example, provide benefits which are costly for the employer to fund but which are viewed as having less value for members. For example, who wants a pension at age 90 which is 3 times their pension at retirement if a much higher initial pension is possible or a 2/3rds spouses pension where the member is single or their spouse has substantial pension benefits in their own right.
However, there is, of course, a well known problem with choice, namely that when left to their own devices people invariably end up taking the wrong option and this must always be guarded against.
What is undoubtedly vital in this process is that the employer facilitates the provision of quality independent financial advice for the scheme members. Trying to circumvent this would be very unwise and likely to raise concerns about the whole approach. The introduction of an IFA to the process is also a wise move from an employer perspective as there is an element of transfer of risk from the employer to the IFA.
Where the IFA becomes involved they must fully analyse all the benefits offered by the scheme (and any additional top-up) and consider not only the yield required to match the scheme benefits but also compare scheme tax free cash, death benefits and early retirement flexibility and then tailor their advice to suit each individuals circumstances. It will only be where the transfer value offers a realistic opportunity to improve the individual’s situation that a positive recommendation will be forthcoming. Furthermore transfer advice can only be provided by an IFA with a specific qualification recognised by the FSA thereby ensuring he has the appropriate knowledge to give such advice.
Given the level of regulation surrounding the provision of transfer advice and the high level of competency required to provide it, it seems unlikely that an adviser would make a recommendation for an individual to transfer where such a recommendation was unsuitable.
The outcome of such an exercise is that if a significant number of members elect to transfer then the Company will need to make significant funds available in the short term.
The trustees’ role in all of this can difficult as they have limited power. True, it is the trustees who agree the transfer basis and therefore can set the benchmark in terms of what they consider a fair transfer value, and clearly this is a key factor. However, if the scheme is in deficit, in reality the transfer value they can pay without extra monies from the employer will be the scaled back transfer value supported by the underlying scheme assets.
Furthermore it is difficult to see how trustees can restrict a member’s statutory right to transfer, particularly where they are aware that a member has received advice from a suitably qualified IFA. Even if a trustee did manage somehow to prevent a transfer they would be leaving themselves open to possible future action from a disgruntled member.
The Pensions Regulator is on record as saying that it is not illegal for members to transfer out in this way, but that certain standards needed to be met. I would suggest that circumstances where a robust and professional advisory process was not in place would fall short of the standards expected.
In addition the Pensions Regulator has warned trustees that they are now required to whistleblow any practices they have doubts about. However, should the enhanced transfer values offered be indemnified by the employer, to the extent that any transfers do not worsen the solvency position of the scheme as a whole and the members interests are being properly considered via the provision of suitable advice, it’s difficult to see where whistleblowing from the trustees will be necessary.
It should at all times be remembered that individuals cannot be forced to take a transfer from the scheme and the IFA has a legal obligation to provide the individual with suitable advice in accordance not only with the TV regulations but also their individual compliance requirements and neither of these will be covered if real value is not being offered.
A transfer option for employers is not the cheap option which many commentators to date have suggested. Poor value will inevitably lead to low take-up so there is an incentive to offer real value. This comes at a cost to the employer and when the cost of actuarial advice and professional financial advice is factored in, providing a transfer option is not a low cost solution. It does however provide members with choice, a chance to appraise their current pension provision with an industry expert and allows often beleaguered employers to place some certainty on final salary liabilities and potentially protect employment.
In conclusion we share the view of the Pensions Regulator that certain standards must be met if companies wish to engage with their current and former employees to better manage their final salary liabilities. Indeed we feel that the Pensions Regulator could usefully consider this area for an additional Code of Practice in accordance with its powers under the Pensions Act 2004.
However, certain criteria should be apparent without the intervention of the Pensions Regulator. 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.
David Davison is a Director at Spence & Partners, independent actuaries and consultants.
Published in Professional Pensions February 2006 and Financial Solutions Magazine March 2006