Defined Benefit pension transfer risks
There is mounting evidence of significantly increased final salary scheme transfer activity taking place in recent months. Evidence of increased activity; Risks to investors Risks to industry; Four important tests to consider ahead of a transfer. What about employer insolvency or scheme failure; what about the high transfer values? From Tom McPhail, Head of policy, Hargreaves Lansdown.
We are concerned by the risks to investors who may give up a guaranteed pension from a final salary scheme in exchange for cash now, only to regret it later. In this post pension freedom world, and with pension transfer values at record levels, it is very easy to be persuaded by the lure of short-term cash. There is mounting anecdotal evidence that not all this activity is robust: for example we are seeing and hearing evidence of targeted sales operations seeking out defined benefit scheme members to persuade them to transfer. We welcome recent government and FCA actions to protect investors, such as moving to ban cold-calling, however it will probably never be possible to completely eliminate the risks to investors.”
Scottish Widows has reported a 170 percent increase in requests for transfer value analyses, compared to the same period last year. Selectapension data shows adviser transfer analysis activity around 50 percent to 100 percent higher than a year ago. FCA data requests on DB transfers from adviser firms. Anecdotal reports from across the industry of substantially increased activity.
The most obvious risk to investors is that the transfer value isn’t sufficiently generous to compensate for the guarantees which are being foregone. If investments underperform, or if the investor lives longer than expected then they may come to regret their decision. Even where they have made their choice because of death benefits, they should be mindful the government could change the taxation of defined contribution pension death benefits in the future.
The risks to the industry are hard to quantify. The large-scale activity on DB transfers which took place between the late 1980s and the mid-1990s, ended up costing in the region of £13 billion, though that also included a lot of opt-out activity. It also had a catastrophic impact on the industry’s reputation, the damage of which still affects relations between the industry and its customers and prospective customers today. Investors are understandably wary of trusting the financial services industry which at the time put its own interests ahead of its customers.
The following four criteria should all be satisfied before an investor goes ahead with a defined benefit pension transfer: The defined benefit scheme can’t meet the investor’s objectives. This could be for example flexibility around death benefits, or flexible income withdrawals for tax planning purposes. Understanding of the investment risks: the investor should understand the risks and uncertainties of a money purchase pension. Capacity and tolerance for loss. If the investor will rely on the money purchase pension for essential expenditure requirements in retirement, the transfer shouldn’t go ahead. Critical yield. For investors not immediately taking pension benefits, the future growth rate required to match the defined benefit pension is an important consideration.
Whilst over the years pension rules and positions have varied, our position has always been that we do not believe a DB transfer to a money purchase pension is in the interests of the vast majority of people. Although the number of requests for advice has increased significantly since the pension freedoms, we remain of the view such a transfer is in the interests of clients only in very particular circumstances, and our position reflects that view.
Transfer values are currently relatively generous, thanks to the way they are calculated and in particular the current low interest rates (by historical standards). There is therefore an argument that if you are going to make a transfer, now is the moment to do it.
Some investors are concerned about defined benefit scheme deficits and the risk of employer failure. Whilst the Pension Protection Fund provides a lifeboat scheme, it doesn’t guarantee full compensation so there is an understandable concern among some investors at the risk of possible loss of guaranteed benefits. Defined Benefit schemes can be inflexible or may have benefit structures which do not match the needs or objectives of an individual investor. These factors can all be a reason to look at the advisability of a transfer however the decision to go ahead should still be subject to rigorous analysis.