A gilt-edged retirement?
I’ve had the opportunity recently to review some final salary pensions in order to determine whether a transfer out may be suitable.
Perhaps unsurprisingly, we’ve seen quite a lot of this type of work over the last couple of months. New pensions flexibility rules mean more and more advisers are starting to question the real value of these so-called ‘gilt-edged’ schemes.
Many of us have an in-built siren that goes off every time a final salary pension rears its head. The default setting for many years has generally been to ‘leave well alone’ and a lot of the time no further analysis has been deemed necessary because, in the vast majority of cases, you’d be crazy to recommend a transfer.
Then the new pension flexibility rules came about.
All of a sudden, the tide seems to be changing and we’re seeing more advisers specifically undertake a transfer value analysis (TVAS) to see whether the client should remain within the scheme, given the extra options and flexibility they could have if they transfer out. This is an incredible shift in the thought process, from what has ordinarily been the polar opposite.
How ‘critical’ is the yield?
In nearly all cases the critical yield still suggests that the client would be ‘worse off’ if they transfer out; however we believe this is becoming a flawed and unrealistic way of determining the suitability or a potential transfer.
For instance, the critical yield calculation is based on the client transferring out of the scheme and into an annuity. Clearly an annuity is used because it’s the closest alternative method to replicating the way in which benefits are paid within a scheme. However, in reality, how many clients are ever likely to use their pensions to buy an annuity in the future?
There’s still a strong argument for annuities, but it’s inevitably going to be a smaller market in the future than it has been in the past. Should we therefore be using a different method to review the pros and cons of a transfer? Perhaps a combination of methods, such as a cash flow plan alongside the TVAS, to demonstrate the effect on a client’s financial position if their either take the scheme pension or if they take drawdown.
Balance and Objectivity
Ultimately, the critical yield has to be balanced with the client’s non-financial objectives – such as providing options for their spouse when they die, or the ability to pass on some of the pension fund to their children. More and more clients seem to be taking that gamble; sacrificing a guaranteed income for life over the prospect of providing more for their family when they die.
These things cannot easily be factored into the equation when a TVAS alone is undertaken. A critical yield of 10% or more doesn’t make a transfer unsuitable if the final salary scheme clearly doesn’t deliver what the client needs from it.
Personally, I am still in the camp that gets a bit twitchy about recommending a transfer out of a final salary scheme – and rightly so; it’s high risk advice. However, it’s more important now than ever before to look in detail at these schemes and question how suitable they really are, given that clients now have realistic alternative options that could be more beneficial in some circumstances.
The question is about balance. This is often mistaken for giving conflicting advice – i.e. a report that says ‘I recommend you do this….but here’s all the reasons why you shouldn’t’. If you really believe that a transfer out is viable and suitable for a client, then there’s no reason in theory why you shouldn’t recommend it. The ‘balance’ is provided by making sure that whatever analysis you undertake to back up your advice is:
- Realistic – particularly in terms of any assumptions/growth rates you use.
- Prudent – it’s good practice to show the client the effect of achieving lower returns than anticipated, or a ‘worst case’ scenario.
- Personal and specific – i.e. you assess and record the client’s needs and objectives in detail and can demonstrate clearly how the advice is suitable for that particular client.
- Well documented and detailed – particularly in terms of recording discussions with the client, what has been agreed, any reservations by either party that have been noted, etc. A good audit trail is always in yours and the client’s interests, no matter what advice is being given.
- Fair – i.e. that you clearly state the risks and potential benefits that the client is giving up by following the advice. That’s not a direct confliction of the advice – it’s making the client aware of the downsides that will inevitably need to be accepted if they transfer. However, you can still state that, on balance, a transfer is still in their interests because of ‘XYZ specific reasons’ that make it suitable in their particular circumstances.
Any suitability report should clearly spell out in as client-friendly terms as possible the pros and cons of any advice to transfer. Quoting the critical yield is always important; but so is context. Can the client afford to take the risk? Why should they? How or why will they be ‘better off’ by taking the chance?
Provided the client has enough information to make an informed decision, they can use the report to fine-tune their subsequent conversations with the adviser that will ultimately determine if they agree that the pros are worth accepting the cons for.
It is also advisable to make the client aware that any advice is given based on a snapshot of where they are in their life at the moment (and on any reasonable assumptions about the future that you may have agreed with them). Any financial advice can only be given based on the current facts and the client’s current position. Advising the client to transfer now may be perfectly reasonable and the right thing to do. However if their position changes unforeseeably in 20 years’ time it could mean that the advice turns out to be less suitable for them in the long run. You need to be clear to the client about these risks – again, giving a balanced point of view in terms of the risks, but still being clear in your recommendations and reasons for them.
Why transfer in the first place?
More and more people are becoming less reliant purely on their final salary pensions when they retire. In a lot of cases, clients have built up retirement funds in a number of different places and a variety of tax wrappers; which is a sea-change from 20 or 30 years ago when people tended to spend most of their working lives in a single company and generally had most – if not all – of their retirement benefits wrapped up in a single final salary scheme.
Coupled with this modern, ‘diversified’ pension savings strategy, people are more consistently living to a ripe old age and are more active for longer in their retirement. Flexibility isn’t just something that people are wanting in their ‘young’ retirement years; they want it well into their ‘70s and beyond, because people of that age are still taking big holidays, giving money to their children, and generally living a ‘good life’.
Despite all of these evolutionary changes, one of the real biggies that has ignited this recent interest in transferring out is that pre-75 dependants’ scheme pensions will still be taxable; whereas the benefits will be tax free on death before age 75 in other types of schemes under the new legislation. When you take things like that into account as well, you start to get some quite compelling arguments for scrutinising the final salary pension more closely.
Just to be clear, I am definitely not saying that we should all instigate a mass-exodus from final salary schemes; the message is purely that our default option should no longer be ‘it’s a final salary scheme, therefore we should leave it well alone’. The default option should be to review the scheme thoroughly – just like we would a client’s money purchase pensions – to make sure the benefits and the way those benefits are structured actually do what the client needs them to do.
In very simple terms, something of ‘value’ does not necessarily come with a specific price-tag.
This is the original version of Kim's latest column for Professional Adviser and was published in its April 2015 edition