Transfer Value Analysis Reports
It is essential that anyone considering transferring out of a Final Salary Pension Scheme Is aware of the risks they are taking on and receives independent advice to ensure a satisfactory outcome. Each Scheme needs to be carefully assessed and a key part of this assessment involves the production of a Transfer Value Analysis Report (TVAR). The TVAR is an essential part of deciding whether to transfer out or keep preserved benefits within the existing scheme.
Employees who have been members of a Final Salary pension scheme and have left pensionable service are referred to as "deferred members". Pension rights which have accrued represent benefits which are known and are preserved by the scheme and paid to the member in the future. These deferred members of a final salary pension scheme are entitled to obtain a transfer value free of charge at least once a year. This transfer value is called the "Cash Equivalent Transfer Value". A deferred member has a statutory right to a transfer until one year prior to the Normal Retirement Date. Please note that some schemes decline to offer a transfer out in the 12 months prior to a scheme's Normal Retirement date.
Cash Equivalent Transfer Values
A Cash Equivalent Transfer Value (CETV) represents the monetarised value, in cash terms of a member of a Final Salary Pension Scheme's accrued benefits. The offer of a CETV is usually guaranteed for three months. For a deferred member, the CETV is worked out by:
- Calculating the member's entitlement at the date of leaving pensionable service. The scheme's accrual rate is applied to the years of pensionable service and the pensionable remuneration on the date of leaving.
- This is then revalued from the date of leaving service to normal retirement age of the scheme using prescribed revaluation methods.
- This revalued pension is then capitalised by working out the cost of securing it.
- Finally, the capital sum is discounted to provide the value in today's terms. The discount rate applied by the scheme is key when calculating the transfer value offered to members, particularly for younger members with a long term until they reach the scheme's Normal Retirement Date.
Transfer of deferred benefits
Swapping a guaranteed pension income for life for an invested pension where the policyholder bears the future investment risk is a complex decision which requires careful consideration of spouse's benefits, cash options, early and late retirement options and the new flexible drawdown rules. Specialist advice is necessary to ensure anyone thinking of transferring understands all the benefits which the existing scheme will offer the member or their survivors and comparing that with the transfer value and how that might be taxed in the future.
The decision to transfer benefits from a Final Salary pension scheme to an invested personal pension or Section 32 Buy Out bond is a complex one but increasingly topical, given the proposed reforms to pensions which will greatly increase the options available to retirees in April 2015 as to how and when they can take their pension benefits. This extra flexibility to allow unlimited withdrawals is not being proposed for those with final salary pensions, where the format of how they take their benefits is much more prescribed. Additional interest has been fuelled by "inducements" offered by Defined Benefit pension schemes offering members enhanced transfer values or cash incentives to transfer their benefits away. Some employers have been offering this in order to reduce the risk to the employer particularly since a change in accounting procedures, called FRS17, have made it mandatory for companies to report deficits from an underfunded Final Salary pension scheme as a liability on their balance sheet. Members of schemes where inducements have been offered to transfer need to assess whether they are being given fair offers where the CETV is at least of an actuarially equivalent value when compared to leaving their deferred benefits in the scheme.
Another scenario where transfers are sometimes, but not always, offered is in the event of a divorce where the accrued rights are subject to a pension sharing order. Please note that some Final Salary Pensions offer membership of the Scheme to the divorcee and may decline to allow a transfer out. The transfer value offered will usually be valid for three months. Careful scrutiny of any CETV is essential to determine whether it has been calculated fairly, particularly if the scheme is underfunded.
Other circumstances where a transfer from a Final Salary pension could be seen as advantageous include when a retiree has an impaired life expectancy having been diagnosed with a medical condition, so a guaranteed but inflexible income from a final salary pension may not be as suitable as taking a transfer to an invested pension. Given the much wider range of qualifying medical conditions taken into account when writing an impaired life annuity, it may also be possible to increase the generosity of the income, particularly for single lives with serious health conditions.
Deferred members with small enough accrued pension benefits may be able to commute them under the "trivial commutation" rules, which currently allow up to £30,000 to be taken as a lump sum. This could be extremely useful for someone struggling with debt repayments. Conversely, there are cases where even if the critical yield revealed by the TVAR is very low, a transfer may not be suitable. This would include clients from families with a history of genetic longevity or members with much younger spouses who have not accrued much pension rights in their own name, perhaps because they have taken career breaks to raise children.
Scheme members who have concerns about the future solvency of their employer may wish to consider taking a transfer- approximately 90% of UK company pension schemes are underfunded and any deficit will have to be met by the sponsoring employer. This is because the statutory protection available from the government for a deferred member of an underfunded Final Salary pension scheme where the employer becomes insolvent invokes protection from the Pensions Protection Fund (PPF). This contrasts with the statutory protection applicable if benefits are transferred away from the scheme, which would be covered by the Financial Services Compensation Scheme (FSCS). A deferred member who is concerned about the solvency of the sponsoring employer should compare the protection available from the PPF with the protection offered by the FSCS because transferring to an insurance environment may ensure greater security than remaining in the corporate pension environment. The risk after transfer is of product provider default but this is minimised by the protection available from the FSCS. In the case of FSCS protection for an annuity plan holder, this is currently 100% of the first £2,000 plus 90% of the remainder. This compares with benefits from the PPF, which are capped for members younger than the scheme's Normal Retirement Age at 90% of the benefits on offer from the employer's scheme, subject to a monetary cap on the pension of £32,760.90 (for the 2014/ 15 tax year).
Transfer Value Analysis Report
A Transfer Value Analysis Report (TVAR) assesses and graphically demonstrates the growth rate required to match the benefits of the Final Salary Pension Scheme following a transfer to a pension scheme which is invested, such as a Personal Pension or a Section 32 Buy Out Bond. This hurdle rate of investment performance required to match benefits from the ceding Final Salary Scheme is referred to as the "critical yield". Critical yields are used to graphically demonstrate "what if?" scenarios by projecting benefits to the scheme's Normal Retirement Age and to earlier or later retirement ages. A compliant TVAR should use critical yields to compare and contrast early and normal retirement benefits, tax free lump sums, death benefits pre and post retirement and options on ill health retirement. Critical yields are also used in the TVAR to include a comparison between a transfer of benefits with a scheme falling under the Pension Protection Fund in the event of the sponsoring company becoming insolvent and unable to meet any pension scheme shortfalls.
Prior to producing the TVAR, we undertake extensive Fact Finding on the member and relate the TVAR results to the member's stated objectives and priorities concerning their attitude to investment risk and capacity for loss, the timing of when and how they want to take their benefits and their view on the solvency of the employer.
The quality and objectivity of TVARs vary widely and we avoid issuing TVARs produced by the pension providers, since not only can these compromise advisory independence but they can also disguise and oversimplify key issues which must be brought to the attention of the member. Due diligence and a proper appraisal should be made of the adequacy of the offered transfer value used by the TVAR. For instance, it is essential to check whether the scheme has, or intends to, equalise all benefits for male and female members by giving them both the same Normal Retirement Age and identical accrual rates for all benefits. The format of the report we offer is prescribed by the Financial Conduct Authority in accordance with the guidance established in Policy Statement (PS) 12/ 8.
Additional issues to consider prior to transfer:
- Whether the Final Salary Pension Scheme has ever awarded discretionary increases to deferred benefits or pensions in payments in excess of the statutory minimums.
- Whether the scheme is over or underfunded. If there is an underfunded scheme it is important to establish whether there has been a commensurate reduction in the value of the CETV. Equally, some schemes may offer an inducement to deferred members to transfer and this can be in the form of either an enhanced transfer value or a direct cash payment, or sometimes both.
- The commutation factor applied by the scheme which defines how much income must be foregone in exchange for a tax free lump sum. This will determine whether the tax free cash lump sum exceeds 25% and, if so, may favour its preservation by opting to transfer to a Section 32 Buy Out, which mirrors the ceding scheme rules, as opposed to a Personal Pension, or Self Invested Personal Pension where it would be restricted to 25%.
- Whether the scheme rules and trustees allow for a transfer out.
- Any restrictions on the tax free lump sum if benefits are taken early, particularly if the pension contains a significant amount of Guaranteed Minimum Pension (GMP).
- What reductions are applied if taking the pension early.
How to interpret the Transfer Value Analysis Report:
To understand what you want from your pension, we will ask you to complete a Pension Transfer Questionnaire. We will then use with the results from the TVAR to determine whether a transfer is appropriate. The Questionnaire is also used by us to recommend a pension provider suitable for the member's needs and to ensure there is an appropriate investment strategy in place. After the transfer is complete, monitoring will be necessary to control when to make withdrawals of cash and/or income, taking into account the taxation consequences.
When interpreting the TVAR, it must be understood by the member that the critical yield uses assumptions which may not reflect what happens in the future. Even if investment returns match the critical yield, benefits paid to the member may be determined by future annuity rates which are very closely correlated to the yield on 15 year government gilts. Since annuity books also hold an element of investment grade corporate bonds, the yield from these bonds also has a direct bearing on the benefits paid to the member should they decide to take their benefits using an annuity in the future. The annuity interest rate used in producing the critical yield is prescribed by the Financial Conduct Authority and so does not take into account factors which could improve the annuity yield and hence reduce the critical yield, such as diagnosed medical conditions. Other assumptions used when calculating a TVAR include future inflation (RPI and LPI) and National Average Earnings.
It is a mistake to use the critical yield, in isolation from other issues, to determine whether or not it is in the member's best interests to transfer. The criteria for "red" or "green" lighting a transfer must go beyond the over simplification of using a "cliff edge" criteria of, for example, any critical yield above 9% should never proceed but anything below this should always proceed. Careful consideration must be applied to the wider consequences of moving from a Defined Benefit to Defined Contribution environment, particularly to the investment risk, death benefits, concerns about employer solvency and benefit flexibility.
It should be noted that for cases where the member is considering taking immediate benefits, provided they can also take their benefits from their existing scheme immediately, our understanding is that this does not constitute a Pension Transfer since it is "at retirement" advice, therefore a TVAR is not required. Instead, comparison of the actual benefits using prevailing enhanced annuity rates can be made against the benefits offered by the existing Final Salary Pension scheme.