News

Posted on 10th October by Graham Laverick

Looking Under the Bonnet

According to a recent survey 55% of defined benefit members who spoke to a financial adviser chose to transfer out in 2016/17 compared to just 36% the tax year before.

 

The question is why are more and more individuals willing to give up their DB guaranteed income for what is perceived as uncertainty as to what they will receive in retirement?

 

There are numerous reasons why transferring out from a DB arrangement can seem a attractive proposition, not least because of the present inflated values.

 

Why are current transfer values so high? The main reasons for this are gilt yields, inflation and mortality.

 

When gilt yields are low, everything else being equal, transfer values are high and vice versa. To combat the impact of the credit crunch, quantitative easing was implemented. This is where the Bank of England purchases government gilts, which reduces their supply, increases the gilt price and in turn, reduces the gilt yield. Gilt yields have fallen by around 3 per cent since 2007 and now stand at around 2 per cent. To put this into some context, a 1 per cent fall in gilt yields could increase a transfer value for a 40-year-old by almost 50 per cent. These extremely low gilt yields mean the value placed by the actuary on a DB pension is high and hence, given the current numbers, is very tempting to those who are considering transferring.

 

Expectation of long term inflation is also a major factor when it comes to placing a value on the pension of members of the in excess of 6000 defined benefit schemes in the UK. The market’s expectation of inflation is now relatively high compared to the last few years. The majority of DB pensions generally increase in line with inflation, when the expectation of inflation increases so does the value placed on them.

 

When it comes to mortality, there are differing views within the pension industry as to whether life expectancy will continue to increase. If people are expected to live longer then the DB pension will be paid for longer and hence the value placed on them will be higher. However recent statistics have shown that mortality improvements in the UK have slowed down and since 2015 have started to worsen meaning people are dying sooner. If this is the case, this will reduce the value placed on a DB pension, although it will only have a small impact, compared to the two former points, reducing transfer values by around only 4 to 5 per cent.

 

The main drawback to members of DB arrangements is their perceived lack of flexibility at retirement and death. The only option the member generally has at the point of their retirement is whether to exchange some of their guaranteed retirement income for a tax- free lump sum. By transferring a DB entitlement to a DC arrangement, recipients are able to access the new pension freedoms that were introduced in 2015, such as being able to take all of their pension as a single lump sum or a series of lump sums. These new freedoms are not generally available to DB arrangements. Individuals may also want more choice at retirement when it comes to securing an income with an annuity. There is also the issue of people with no financial dependents so any attaching dependents pension is of no benefit to them. In a transfer value calculation, regardless of their circumstances a value is placed on this, by transferring out they can potentially increase the benefits they would receive.

 

DB arrangements generally increase once in payment. So, as an individual gets older their retirement income increases. In the early years of retirement, the trend is that people are more active and spend more to pay for their active lifestyle. So, as they slow down they do not need so much income but their DB pension keeps on increasing. Transferring out gives the flexibility to have a non-increasing income which means that an inflated income can be taken at outset when it is most needed.

Death benefits in a DB arrangement are not particularly flexible and generally upon death a pension is paid to a financial dependent and, depending on the circumstances, a lump sum may be paid as well.

 

If the individual dies relatively young and or without a financial dependant then a fair value of the benefits may not have been paid.

In a DC arrangement upon death, if an annuity has not been purchased then the attraction is that the remaining value of the individual’s fund is paid to beneficiaries. Depending on the options successor generations can also benefit from the funds.

 

There has also been a lot of bad publicity to DB arrangements. You need only look at the fiasco around the BHS scheme with Philip Green ending up paying £363Million to ensure the security and also for BHS members to lose out as their benefits were also reduced. Then we have the British Steel Pension Scheme which has over 130,000 members. They have now been given the option to transfer to a new scheme that will have a contribution from Tata Steel of £550 million plus a third stake in Tata Steel (UK) but will concede lower increases to their DB pensions in the future.

 

Is transferring out of a DB arrangement the right choice? It is a legal requirement for an individual to take independent financial advice if the value of their DB transfer value exceeds £30,000. It maybe that taking everything into account the advice from the IFA is not to give up this guarantee, so a partial transfer could be the solution.

 

With a partial transfer, as the name suggests members can transfer part of their DB pension out of the scheme but still retain a partial DB guarantee. Although the majority of DB schemes do not currently allow a partial transfer and normally insist on an all or nothing approach we are starting to see a change with now more and more schemes allowing a partial transfer.

 

Transfers out are good news for DB schemes as when an individual does transfer their benefits it does remove liability and risk from the scheme’s balance sheet. In addition, the transfer value paid is lower than the amount set aside for prudent funding purposes hence improving the scheme’s funding position and the security for the remaining members. In which case the individual would not have transferred out if partial transfers had not been allowed.

 

Many schemes will claim administration issues make it hard for them to offer partial DB pension transfers. In some cases, partial transfers are not well publicised and individuals are not aware of them. Partial transfers should become a standard offering.

 

As always individuals should seek professional help and not just look at the headline transfer value it’s all about looking under the bonnet.