DB Pensions Transfers: The final frontier
It is no secret that the change in pension legislation in April 2015 opened up a massive opportunity for clients to access benefits in final salary/defined benefits pension schemes.
Historically, it is fair to say that a lot of us have felt very uncomfortable with the concept of transferring a client out of a final salary scheme – to the extent that it was not uncommon for advisers to avoid undertaking any detailed review of a client’s benefits in such schemes.
The rule of thumb had been that a client would – except in a very few limited circumstances – be ‘worse off’ if they transferred out; hence it was a no-brainer to stay put and therefore no further analysis was required.
Thinking the (once) unthinkable
Pension freedom has certainly challenged this thinking. Whilst in the vast majority of cases a client would – in terms of pension income – still be worse off as a result of transferring, I strongly believe that the significant options available to a client now mean that we can no longer take final salary schemes for granted.
When we review a client’s money purchase pensions to determine whether they are suitable and fit for purpose, we need to be reviewing their final salary schemes at the same time for exactly the same reasons. Even if the end result is that they should still remain in the scheme (which, in most cases, is likely to be the right solution), the important thing is the review itself. If we exclude a final salary scheme from our detailed analysis of a client’s arrangements, we are only doing half a job.
This is all well and good, but most of us aren’t that experienced at reviewing final salary schemes and completing a transfer value analysis (TVAS). Personally, I am AF3 qualified. This means that I have learned the theory behind final salary schemes, how they work, the different types of benefits and how they are calculated.
However, AF3 – and indeed no other professional qualification that I know of – does not teach you the practical application of how to understand and interpret the information you are given by the scheme administrators and how to transpose it into a TVAS system to produce an accurate output.
This is a serious problem. It means that the only people that feel confident working in this advice area are people that already have a significant amount of experience in dealing with occupational pension transfer analysis. And you don’t get experience without breaking a few eggs along the way.
The trouble is that, with final salary transfer values typically being in the hundreds of thousands of pounds, this isn’t an area that you really want to cut your teeth in unless you’re working alongside someone who does have that experience and expertise, and who can mentor you and check your workings.
How to develop experience in the face of rising demand
The shift in the market towards reviewing and advising on final salary schemes is massive. I have dealt with more final salary transfers in the last three months than I had in nearly 20 years in the industry before this all came about.
The momentum is also increasing, More and more advisers are dipping their toes into this market and realising that – in some instances – it is frighteningly easy to justify transferring out of a scheme that until April 2015 they may have regarded as virtually ‘gilt edged’. This is evidenced by a number of high profile ‘pension unlocking’ companies springing up all over the place.
So how do you review a final salary scheme if:
a. You’re inexperienced at it and aren’t confident of what you’re doing, and
b. How do you construct a compliant suitability report (irrespective of whether the advice is to remain in situ or to transfer)?
In answer to point a), you have two choices.
Firstly – and this is my preferred route – find yourself a mentor who is very experienced at reviewing and advising on final salary schemes, and get them to teach you how to produce an accurate TVAS.
Bear in mind, though, that every scheme is different and a TVAS is notoriously hard to get right unless and until you have sufficient experience of producing them to know when something doesn’t look right.
This can take years, and in my own experience, it is unfortunately one of those instances where you simply have to learn the hard way. In other words, you consistently get told that you’ve done it wrong until one day (hurrah!) you finally get one right. After that, the ratio of TVAS reports you get right to those that you get wrong slowly improves until the point that you can do them in your sleep. Practice makes perfect.
Secondly, if you don’t have a mentor who can teach you and painstakingly proof every single TVAS you produce, then you should outsource the production of the TVAS to an external company that specialises in them – the likes of O&M and Selectapension, among others, offer independent TVAS services.
Each time they produce a TVAS you can compare what they’ve done with the information provided to you by the scheme administrator and learn how the specialists transpose that information into their systems.
Both methods will take a long time to learn. Each scheme is unique and some of them have very odd quirks and features that are hard to replicate through a fixed TVAS system. The most important thing, though, is that you don’t attempt to produce a TVAS and give advice – either directly or, if you are a paraplanner, via an adviser – on final salary schemes unless you are competent in this advice area or your work is being proofed and signed off by someone else that is. The possible outcomes of getting the numbers wrong and ending up on the wrong end of a client complaint could be severe and highly costly for your firm.
How to create a compliant suitability report
Final salary schemes are notoriously complex and full of jargon that is extremely difficult for a client to understand. Heck, it’s hard enough if you’re a financial planner!
There is a real temptation – and it would be very easy – to write a report that says to the client “this is a really complicated subject, so we’ve really earned our fees here”. However, the real skill in paraplanning is taking something extremely complicated and translating it into a language that clients will understand and feel comfortable with, so they can make an informed decision.
It is not about ‘dumbing down’ – which is an expression people confuse with ‘writing in plain English’ – but about remembering that clients are intelligent and often well educated people, who generally haven’t worked in our industry and cannot be expected to understand our lingo.
In these days of growing interest in accessing pensions flexibly, it is well understood in our industry that the critical yield generated by a TVAS is of less relevance than it had been in the past.
Historically, the decision to transfer out of a scheme has typically been based on the critical yield and/or the scheme’s funding position. Nowadays, the critical yield is one of a much greater number of equally important factors to consider.
The most essential points to take account of, and document in the suitability report where relevant, include:
- The client’s retirement objectives: when are they looking to take benefits? How much do they need? Will the amount of their withdrawals need to vary or are they likely to remain fairly consistent?
- Their family situation: e.g. are they married? Do they have children? Who are their ultimate beneficiaries?
- Their health and potential life expectancy: take extreme care on recommending transfers where a client is in ill health as it can create an Inheritance Tax liability if they die within two years of transferring a pension
- Their financial situation: what other sources and levels of income will they – and their partner – have in retirement? How much other capital and liquid reserves to do they have available? What rate of tax are they likely to pay in retirement?
As an outsourced paraplanner, I often receive pension transfer cases where the most common client objectives that have instigated the review of the scheme are to have greater income flexibility and the ability to leave death benefits to anyone the client wishes, in particular adult children.
These are reasonable and feasible objectives, which a typical final salary scheme would not be able to facilitate. However, what we have to do is quantify the cost to the client of achieving these objectives.
Achieving client clarity with cash flows
Clearly a critical yield figure is of limited use in this case because an annuity is unlikely to meet their objectives either. Therefore, the only way we can demonstrate the likely cost is by including a cash flow analysis in the report.
When we include a cash flow analysis in a final salary transfer report, we show the Cash Equivalent Transfer Value (CETV) dropping into the client’s ‘bucket’ at the very start of the analysis. Then we project its value by assuming that 25% of the fund is added tax free and that the residual value of the fund is paid net of tax (based on what we’ve calculated to be their notional marginal tax rate in retirement, given their other incomes and the level of their anticipated drawdown withdrawals).
The rate of growth applied to the cash flow will also be reduced by the anticipated rate of inflation and the ongoing charges of the receiving scheme arrangement and advice fees. We then assume that they take withdrawals from their ‘bucket’ at the scheme’s normal retirement age, at the same level as the projected scheme pension at that time, increasing in line with inflation each year.
The cash flow will normally show a gradual decline in the value of the client’s fund over the course of their retirement, and may show them running out of money at some point before age 100. This gives the client a clear and visual representation of the ‘cost’ to them of meeting their objectives, and of the risks they would be taking. It helps the client place greater emphasis in their minds on just how badly they want to meet their objectives, or whether it’s something that’s ‘nice to have, but I don’t want to take that kind of risk’.
Cash flows are often a sobering experience for a client when put into this context and are an excellent mode of determining the priority of their objectives.
Account for factors influencing cash flow beyond CETV
An equally important exercise is to review the cash flow position not just taking into account the CETV on its own, but also including all their other assets and income.
Affordability and capacity for loss are extremely important in determining the suitability of a final salary transfer and, in my mind, have taken over from the critical yield as being the new ‘be all and end all’ of pension transfers.
If you can demonstrate to a client that, taking into account their overall wealth, capacity for loss and appetite for risk that they can comfortably afford to take the risks, then this may make a transfer more suitable in their circumstances – provided it is in line with their needs and objectives.
As far as the suitability report is concerned, remember that the TVAS is a separate document that contains all the detailed analysis and jargon. The suitability report should be read in conjunction with the TVAS and should ideally just give a simple and clear overview of the TVAS output and relate that output to how/whether it meets the client’s objectives and affordability.
I quite like the use of tables summarising each of the main factors – e.g. tax free cash, death benefits, pension increases, flexibility, scheme security etc. – and, on one side of the page, explain how each of these is treated through the final salary scheme while, on the other side of the page, explain how it would be treated if the benefits were transferred to an individual pension scheme.
It makes it easier for the client to make a direct comparison, and for you to summarise at the end of the table which of those factors meet the client’s needs and objectives best, followed by the cash flow analysis described above.
This can either be a stand-alone analysis report, or it could then go on to recommend a suitable receiving scheme if a transfer is to be recommended.
Whatever way you go about it, I strongly suggest that you:
- Know what you’re doing, or work with someone that understands the TVAS and final salary transfer process very well and can provide you with a high degree of mentoring, monitoring and training until you find your feet.
- Are very clear on the client’s objectives and current financial/personal situation. Where possible, it would be best to get a client to confirm their retirement objectives in their own words – it is very easy for us as financial planners to have a high degree of influence over a client’s objectives and we must try not to put words or ideas into their minds.
- Can demonstrate clearly that the client has the capacity and appetite to accept the considerable risks they would be taking by transferring.
- Have a clear and demonstrable process for reviewing final salary schemes and compiling the suitability report.
- Ensure the person signing off the report has the appropriate permissions and qualifications to advise on occupational pension transfers.
- Have your final salary transfer reports regularly checked (prior to issue) by your compliance consultant to ensure that the content and process are correct, complete and compliant.
This is the original version of Kim's latest column for Professional Paraplanner and was published in its December 2016 edition.