Calculations of pension transfer values for defined benefit schemes should be made simpler and fairer to the transferring employee claims Standard Life.
In its response to the Department for Work and Pensions’ consultation into transfer values, Standard Life picks up on the fact the consultation notes only 8% of transfer valuations actually result in transfers.
John Lawson, head of pensions policy at Standard Life, says he would be surprised if the percentage across the whole of the pensions industry would have an average closer to a 5% completion rate.
He claims this is because the transfer values are generally poor value for money, with the transfer value not matching the benefits being given up in a final salary pension scheme, because:
- The discount rate assumptions are excessive
- The mortality rate assumptions are heavier than should be expected
- The transfer value is normally reduced because the scheme is underfunded
In its consultation, which closed on Friday, the DWP outlined three possible methods for calculating DB transfer values after the Actuarial Profession asked the government to step in when its consultation on proposals to replace Guidance Note 11 (GN11) with Exposure Draft 54 (EXD54) met with differing views.
EXD54 caused concern among both actuaries and the wider pension industry as it proposed to assume transfer values would only achieve a rate of return equal to bonds meaning transfer values would need to be higher to compensate.
However there were fears this method of calculation could lead to a weakening of DB schemes, as the higher values could encourage more people to switch to defined contribution (DC) schemes, leaving employers to foot the bill, with the possibility some would decide it would be easier to close the scheme than increase contributions.
As a result the DWP outlined three options, asking the industry for feedback on which is the best way forward:
- Prescribed Assumptions
- Scheme Specific Basis
- EXD54 Basis
Alasdair Buchanan, group head of communications at Scottish Life, says out of these three options there is really only one winner, the scheme specific funding, as it achieves the best balance between giving the transferring employee a fair value but also being fair to the remaining members of a scheme.
However Lawson, in Standard Life’s response to the DWP outlines a fourth way forward which takes away the ability for scheme actuaries to use their discretion, with Lawson suggesting this is the main reason for low transfer values, as the actuaries are using weak assumptions because they work for the employer.
But he admits as each of the three methods put forward by the DWP have their strong points, Lawson says Standard Life’s fourth possibility offers an approach which draws on the best parts of each method.
At the moment he says advisers have to, under the Financial Services Authority’s (FSA) Conduct of Business (COB) Rules, obtain an automated Transfer Value Analysis Statement (TVAS), to decide whether or not to recommend a transfer.
However Lawson says on average the TVAS report shows the nominal rate of return on a transfer value between the date of transfer and retirement is between 8.2% to 10.2%, but the likely real rate of return from equities over the long term would be between 7% to 8%, with expected inflation at 2.5%.
He says intermediaries are then advising clients against transferring as this means people transferring out of DB schemes need to achieve a return well above that normally expected from equities just to match the benefit being given up, and with the probability of equities outperforming is very slim, the risk of receiving less at retirement after transferring is very high.
As a result Lawson says Standard Life would like to see an approach which would have discount factors based on the asset mix of the fund, so instead of either a low bond rate yield, as proposed by the EXD54 approach, or an unrealistically high equity return, the discount rate could be a weighted average of the different investments.
But to do this Standard also recommends the Government Actuary's Department (GAD), either on its own or as a joint committee with the Institute and Faculty of Actuaries, should set a prescribed rate of return for the different asset classes, such as equities, property, and bonds so there would be consistency within the calculations.
Lawson also suggests mortality rates could become more realistic by an independent body publishing a set of around six mortality tables classed by industry or social class to make sure the transfer values are appropriate to the job people do, as those who do white collar work are likely to live longer and need a higher transfer value than those who do more manual work.
Buchanan says the main thing is the outcome is a balance which is fair to everyone, not just those people preparing to transfer out of a scheme, particularly as workers have been encouraged to switch out of their DB scheme now so they get a high transfer value.
He says: “People are being encouraged to do this so they can avoid the possibility of the scheme winding up, but this is not fair to the scheme, and the members still left in it who are suffering because the transferees are getting a larger share of the fund than they should. “
Buchanan says the system should be fair and be consistent as the problem with making transfer values too generous is it could badly damage the scheme and the remaining members.
But Lawson says while Standard also don’t want scheme to be able to reduce transfer values unless the scheme is funded to 90% or less, he doesn’t believe its proposals will damage the already vulnerable DB schemes.
He says: “Employers will have to fund their deficits anyway under scheme specific funding, so I don’t see why transferring employees should lose out on that. If a scheme is underfunded then the difference between the reduced transfer value and the full one should be made up by the employer, not the scheme.”
Lawson points out the approach will not only make it fairer for employees but will also benefit the scheme as the rates of return will be decided on the actual asset mix, which is better than the EXD54 approach which only uses a bond yield rate, which if the fund is invested in equities, means the scheme could be paying a much lower discount rate than they need to.
“We are calling on the DWP to draw a line under the current calculation and replace it with one that is fair to transferring employees,” says Lawson. “It is their deferred pay and they should have a free choice what to do with it, without having to suffer draconian financial penalties.”
Meanwhile the Association of British Insurers (ABI) has supported the scheme specific method in their response, as it would work well with the new scheme funding requirements.
It says this method would be easier to communicate to trustees, as they would already be agreeing how to fund the scheme on a prudent basis and margins then taken out for the transfer value.
But it does warn there is more work needed to be done to assess the impact on small schemes and whether the technical provisions would always be fair to members. It recommends in such cases, there should be increased disclosure to members to ensure they have sufficient information to understand this.
But despite this the ABI has suggested information on transfer values should be generic in nature, and it disagrees with the suggestion of making the use of an IFA compulsory when deciding on a transfer, although it admits most people would probably chose to use one.
Like Lawson, the ABI also disagrees with the idea of transfer valuations only being available every three years, as it says because people’s circumstances change quite quickly, limiting the review to every three years would be quite onerous.
Jonathan French, spokesman for the ABI, says: “We’re pleased the DWP is looking into this area, as we need to find a way forward which is fair to everyone involved. We support the scheme specific method rather than the prescriptive option as it should depend in the scheme involved and decided on a case by case basis.”
If you have any comments you would like to add to this story or would like to speak to its author about a similar subject, telephone Nyree Stewart on 020 7968 4558 or email [email protected]IFAonline
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