Final salary pension transfer values may be increasing but it is important to remember a final salary pension offers a number of benefits that should not be given up without detailed consideration. A Transfer offers flexibility and potential benefits for beneficiaries but there are also risks.
A high transfer value (the correct term is a Cash Equivalent Transfer Value) can mitigate those risks to a point. It can potentially tip the risk vs reward calculation towards the transfer option. However, each case has to be looked at on its individual merits. A transfer will not be the right way forward for the majority but rising transfer values can make a pension transfer at least worth investigation.
A Defined Benefit (final salary) pension transfer valuation can increase (or decrease) for two main reasons:
- Decisions the Trustees make on the long term strategic direction of the pension scheme.
- The impact of financial and economic factors on the value of Gilts
Strategic Direction Of The Pension Scheme
To understand why a pension Trustee may wish to increase final salary pension transfer values it is first important to understand the role of Trustees and those they rely upon for support.
What is a Trustee?
Workplace pension schemes in the UK are set up as trusts to ensure pension assets are held separate from the assets of the employer. A Trustee is an independent person (or company) whose role is to oversee the pension fund and ensure funds are secure. Their activities are controlled by the Pension Regulator.
Trustees must always act in the best interests of the pension schemes beneficiaries (those retired and those still to retire).
What Is An Actuary
Pension Trustees take advice from a wide range of professionals before making decisions on the best way forward for the pension fund. One of their key advisers is an Actuary.
The key responsibility of an Actuary is to advise Trustees on the value of a pension fund and its liabilities. Actuaries are also responsible for ensuring pension transfer valuations are fair and calculated in accordance with scheme rules and regulations.
What Is A Pension Manager
The key duties of a Pension Manager are investing the pension fund to deliver the best return while managing risk. They are also responsible for reporting on the pension funds financial performance to the Trustees. They often manage a team of pension administrators.
How Is A Final Salary Pension Scheme Organised
Final salary pension schemes have three groups of members, active members, deferred members and members in retirement and receiving a pension.
Active members remain in the sponsoring company employment and pay contributions to the pension scheme. Deferred members have left the employment of the sponsoring company and are no longer allowed to pay into the scheme. They have a right to a pension when they retire based on their (and the sponsoring companies) contributions while they were in employment.
What Are The Objectives Of A Final Salary Pension Scheme
The objectives of the scheme are simple, they are to manage the pension fund to the benefit of the membership and deliver the pension each member is entitled to when it becomes due. A calculation must be made on the level of contribution required by both the employee and employer to deliver the promised pension.
An individual’s final salary pension entitlement is a function of salary (final or some average), years service, any additional contributions and some predefined multiple.
The real value of money potentially many years into the future must be accounted for and that means some growth of the pension fund is required to cover the impact of inflation. Most defined benefit pension schemes tend to invest in relatively low risk, relatively low return investments such as Gilts. This investment strategy is a major factor in transfer valuations (see below).
Why Would A Trustee Consider Increasing Transfer Valuations
Valuing the amount to be paid from a final salary pension scheme over many years is a complex calculation based on a variety of assumptions. The calculation must factor in future inflation rates, interest rates, economic prospects, investment returns and longevity rates.
Market forces driving down the returns on Gilts (see below) have pushed many final salary schemes into deficit. A pension scheme in deficit has insufficient funds to pay what is due to its members in future. According to the Pension Protection Fund (in January 2015) from the 6,057, private sector final salary pension schemes surveyed 4,936 were in deficit. With many employees and deferred members yet to retire this is not necessarily a problem provided the shortfall is made up at some point.
If a pension scheme has a deficit there are several potential ways forward. There may be evidence that economic factors will change, improve investment returns and thus reduce the deficit. Alternatively, the sponsoring company may decide to pay more into the pension fund to address at least part of the deficit. Or, the scheme may choose to reduce the membership of the scheme by incentivising deferred members to transfer out.
The Trustees in discussion with the Actuary may decide to remove some of the long term fund liability by offering deferred members of the scheme an attractive final salary pension transfer valuation (CETV) in an effort to encourage them to transfer out of the scheme. However, the Trustee must be careful to ensure the numbers of transfers out do not put benefits due to the remaining members at risk.
Setting a transfer value is a matter of judgement based on the information available on a range of factors at a specific point. It is not an exact science. Any one factor changing significantly will force a re-assessment of the situation. This can lead to pension transfer valuation movements (up or down).
The Value Of Gilts.
Final salary pension schemes tend to use the contributions they collect to buy a long term (safe) income. They use this income to pay pension benefits to those already retired while keeping a close eye on the profile of their future liabilities (those nearing retirement). To secure a safe, predictable income final salary pension scheme managers tend to buy UK Government Bonds (known as Gilts).
In times of economic uncertainty, particularly when inflation is relatively low, investors tend to buy Gilts as they are perceived as a safe investment. This tends to force up the price of Gilts on the open market.
As the price of a Gilt increases, the yield (the income expected from that Gilt) falls – it is an inverse relationship. Since the financial crisis in 2008, the yield on Gilts continued to fall from approximately five percent in Mid 2007 to an all-time low of less than one percent in August 2016. Many factors contributed to this fall but there has been a small recovery in yields since the low point.
Partially as a result of low Gilt yields and partially due to the methods used to calculate future liabilities many final salary pension schemes are in deficit.
When calculating the final salary pension transfer values scheme Actuaries tend to take account of how much it would cost a person to buy the same income provided by the final salary pension scheme if they had to buy an annuity on the open market. Annuity rates are linked to Gilt yield and are therefore comparatively low. Hence, the higher the transfer value required to purchase the required annuity income.
As discussed above some final salary schemes are prepared to offer incentives (by further boosting transfer values) to members of the scheme to transfer out. This reduces the scheme’s long-term liabilities.
Transfer values may be relatively high but there is no guarantee the situation will not change in the short to medium term. Successive Governments have a history of changing pension and/or tax legislation. Even a small change in Gilt yields could cause a major re-think on transfer values.
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The information in this article does not constitute financial or other professional advice. You should not take action on the basis of this article without seeking regulated independent financial advice that addresses your specific circumstances. Past performance is no guarantee of future returns. The value of your investment is not guaranteed and you may not get back the full amount invested.