Employers’ concerns over defined benefit liabilities should ensure that enhanced value transfers are here to stay, Matthew Craig reports.
As Jane Austen moght have said, had she been a pensions consultant, it is truth universally acknowledged that a finance director in possession of defined benefit (DB)†scheme must be in want of reducing its liabilities.
Offering scheme members an enhanced transfer value (ETV) is one way to reduce DB liabilities. The essence of an ETV is that it makes financial sense for an employer to offer scheme members a boost to their transfer value to encourage them to leave the scheme. For example, the funding cost of a pension could be £150,000 but the actual transfer value £100,000. If the member accepts an enhanced transfer value of £120,000, with the company adding the extra £20,000, the FD will have reduced his DB liability.
The background to ETVs is that transfer values, which were widely pegged to the minimum funding requirement (MFR) as introduced by the Pensions Act 1995, fell to very low levels, as the MFR weakened due to market conditions and legislative tinkering. As a result, DB transfer activity largely ceased. However, the government then decided that, from 11 June 2003, solvent employers could not walk away from an underfunded DB scheme but had to fund it to the level at which it could be bought out with an insurance company, dramatically increasing DB liabilities as the full buyout cost was, and still often is, prohibitively expensive. For ongoing schemes, scheme-specific funding rules have also raised funding levels, particularly for schemes with a weak employer covenant. As Charles Cowling, managing director at Pension Capital Strategies, puts it: “With transfer values so low, an interesting option suddenly appeared for FDs. Rather than trying to sway trustees, why not give a cash incentive to the member? It could be very substantial and still leave the company in a better position.”
ETVs can be seen as a part of a general strategy of containing DB costs. Aon Consulting principal and actuary Paul McGlone comments: “It is almost impossible to deal with a pension scheme as a single entity but you can break it down. For pensions in payment, a buyout may be possible. For deferreds, ETVs can be useful. For active members, scheme design or investment strategy can be considered.”
The practice of offering ETVs to members is still evolving, but a broad pattern is emerging. Barnett Waddingham partner Clive Grimley says: “The first step is to check the current basis for transfers offered by the scheme. We’ve seen a case where halfway through negotiations, the trustees suddenly changed the transfer value calculation basis and the transfer values shot up.”
The FD must then check that all the relevant numbers stack up. Grimley explains: “The FD must have a clear idea of the FRS 17 value of the scheme, the buyout cost and the current transfer values so he can see what the differentials are.” The next stage is for the scheme actuary to model by how much transfer values should be enhanced to allow an independent financial adviser (IFA) to advise members to take a transfer.
Getting independent financial advice on a transfer is seen as very important, both to protect the members’ interests and to safeguard the employer from future legal action. In addition, some providers of defined contribution pensions will only accept a DB transfer if independent advice has been given. One option is for an employer to select an IFA firm and to pay for the cost of advice, although this could constitute a benefit-in-kind. Alternatively, an IFA may be paid on a commission basis, but should still follow the regulations laid down for a pension transfer.
In considering the benefits of a transfer, IFAs assess the critical yield needed for the transfer value to match the DB benefit being given up. Kevin Wesbroom, Hewitt Associates UK lead, global risk services, comments: “It is a calculation you can solve and it gives the critical yield. The higher the yield, the less likely you are to get your money back.”
AWD Chase De Vere Consulting corporate consultant Liz Kane says that a member will go through the full advice process, examining their pension provision, attitude to risk and individual circumstances. “If the critical yield is too high we won’t recommend it. If it was 9% we think that’s unrealistic for anybody,” Kane says. She adds that a critical yield of around 6%, with some variation for the time to retirement, attitude to risk and other factors, is seen as acceptable.
In general, members close to retirement will generally want to sit tight, while younger members might see more benefit from a transfer. Employees with substantial accrued benefits in their late 40s and early 50s are seen as a ‘sweet spot’ for transfers – representing significant liabilities for employers – so may be targeted in an ETV exercise. One controversial issue in ETVs is the use of a cash lump sum as part of the offer to members. Cash is subject to tax and National Insurance but is highly attractive to scheme members, and is widely acknowledged as increasing the take-up rate in ETV exercises. Kane comments: “Cash is not our preferred option. It certainly influences members in a way we would not want them to be influenced, and makes advice more difficult.” Similarly, Fidelity head of DC business development Julian Webb says: “We would feel uncomfortable where a cash enhancement is being made. We think people make inappropriate decisions when they have been offered cash.”
However, others point out that individual members may need immediate cash to clear debts or mortgage arrears, or it can be paid into the pension fund. Towers Perrin principal Mark Duke says the presence of cash can make the transfer value irrelevant: “You may find some ETV exercises where advice has been given, and in quite a lot of cases the individual has been advised not to do it but they have done it anyway to get the cash.”
For employers, risk to reputation is an issue to be considered. Duke says employers have to decide what style of ETV they want to be associated with. Alexander Forbes Financial Services technical product development manager Jarrold Parker comments: “FDs should make sure members are given very good information on which they can make an informed decision. Communication is the key to a successful inducement exercise.”
Predicting the take up rate in a pension transfer can be problematic. Too low and the exercise is a waste of effort, too high and it will be expensive, signifying an over-generous offer. McGlone said take up rates of 30-70% are typical, depending on how the offer is communicated and those involved. On the other hand, Webb says a take up of 20-25% is more typical.
An ETV exercise can be quite costly, with McGlone estimating set up and advice costs at around £1,000 per member. If the exercise is to be conducted on large scale, it may be done in phases, so an IFA can cope with advice requests.
Concern that members could lose out in ETVs has sparked regulatory attention. The Pensions Regulator issued guidance last year, but this has been interpreted by many as a best practice guide. More recently the Financial Services Authority (FSA) warned against “direct offers” to members without independent advice. Parker says: “The FSA is really saying members will find it extremely difficult to make an informed decision if they just have a pack sent to them. We will no longer participate in ETVs on a direct offer basis.”
Given employer concerns over DB liabilities, ETVs are here to stay. They may seem like an exercise in cynicism to some, but pension advisers say that if they are properly communicated and offer value to members then they are a legitimate activity.
Hewitt’s Wesbroom says many FDs will take a pragmatic approach: “There may well be a compromise between a whiter-than white approach and keeping the costs within bounds. That is the sort of trade-off that FDs understand.”
• Offering defined benefit pension scheme members an enhanced transfer value (ETV) is one way to reduce DB liabilities.
• With current low transfer values some FDs are using the opportunity to give cash incentives to members to transfer out of DB pension schemes.
• FDs must check that all the relevant numbers stack up, they need to know the FRS 17 value of the scheme, the buyout cost and the current transfer values. The scheme actuary needs to model by how much transfer values should be enhanced to allow an independent financial adviser (IFA) to advise members to take a transfer.
• Getting independent financial advice for employees on a transfer is seen as very important, both to protect the member’s interests and to safeguard the employer from future legal action.
• Predicting the take-up rate in a pension transfer can be problematic. Too low and the exercise is a waste of time and effort, too high and it will be expensive, signifying an over-generous offer. An ETV exercise can cost around £1,000 per member.
• The Pensions Regulator issued guidance last year, but this has been interpreted by many as a best practice guide. More recently, the Financial Services Authority (FSA) warned against ‘direct offers’ to members without independent advice.
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