Why Transfer Value Comparators are Flawed
A pension transfer from a defined benefit pension scheme (otherwise known as a final salary scheme) means giving up your scheme benefits in return for a cash value (often enhanced) which is invested in another (defined contribution) pension scheme, often a SIPP or QROPS for British expats. There are many reasons expats consider transferring out of a DB scheme, including the ability to access funds at an earlier age, taking a 25% tax free Pension Commencement Lump Sum (PCLS), consolidating two or more pensions into one scheme, having more control over the investments and, of course, calming employer insolvency worries as many schemes in the UK run into funding difficulties and deficits.
Transferring often comes with higher costs and the risks that come with investing in financial markets, so anyone considering a transfer should make sure they fully understand what they will be paying and what they will be giving up, ensure their adviser is suitably qualified to give advice and any investment arrangements are commensurate with an agreed and acceptable level of risk.
The Financial Conduct Authority (FCA) is the government watchdog that regulates the pension advice industry and they are rather clear regarding their stance on DB pension transfers. The FCA rules still stipulate that an assessment of DB to DC transfers must start with the presumption that it will not be in the client’s best interests.
- “The FCA continues to believe that for the majority of people it is not in their interest to transfer out of a DB pension”.
- “Where an individual seeks advice to transfer it is important that advice given is suitable and appropriate for their needs and situation".
Joint guidance from the Pensions Regulator and FCA was published in March 2021 with a focus on what trustees can do to help members without straying into advice or arranging investments.
"It remains our view that usually staying within a DB scheme would be the best option for the consumer. What we don’t want is employers or trustees pushing employees and members out of the safe space because of an objective to derisk a corporate balance sheet.”
However, staying in a defined benefit pension scheme is not risk-free and it is questionable whether this is still relevant in the post-pension freedoms market and at a time when many DB schemes are in deficit. If your employer is still in business, it usually has to make sure the scheme has enough funds to provide the full entitlement to members. But some employers sponsoring these schemes have gone bust (BHS, Carillion etc.), not leaving enough money to pay the pensions promised. If an employer is going out of business without enough funds in its pension scheme, the Pension Protection Fund might be able provide compensation, but this might not be the full amount of the pension you’ve accumulated.
If the value of your DB scheme is over £30,000 you’ll have to take advice from a regulated financial adviser before you can transfer. This rule is there to protect you and make sure you’re aware of all the pros and cons of transferring. This advice is produced in the form of an Appropriate Pension Transfer Analysis (APTA) report. The review, in most instances, tells you not to transfer. But the comparison formula cemented by the FCA is unfair so the DB analysis will always give a negative outcome.
The FCA says all advisers need to work to the same framework so savers can easily compare the benefits and drawbacks of different schemes. But nobody transfers from a DB scheme in order to buy back exactly the same benefits in a DC scheme. That would be like pawning your watch and then taking the money to a different shop and buying the same watch.
In the past, showing people the investment return they would need from that pot to support their income needs, the critical yield, was the main tool used to qualify the transfer offer. But the regulator went further by introducing its own big number, representing what the cash value would be if it was left inside the scheme or, to put it another way, as if it were risk-free.
The transfer value comparator (TVC) is the tool it created to generate these big numbers. And they are very big. The TVC calculations generate ‘huge numbers’, which are confusing to clients. Regulatory experts agree the figures can be a ‘big shock’ to clients and provide an ‘unfair comparison’.
It was originally proposed that when working out the amount needed to reproduce safeguarded benefits firms should replace a required rate of growth with an appropriate discount rate. ‘This discount rate should be appropriate for each client,’ the FCA said, ‘based on their attitude to risk, irrespective of whether the proposed receiving scheme will involve flexi-access drawdown or an annuity.’ This seemed the right way to go.
However, for contentious reasons the FCA ended up deciding the risk-free rate would be determined from published gilt yields and dependent on the term until benefits become payable. And this is where the problems are. These rates are often tiny or negative, giving rise to the standard negative DB transfer report. Pension savers will never have risk-free investment of their funds, and as savers meet the costs of a DB transfer which reduce the fund value, the DB transfer analysis is always likely show a recommendation not to transfer. Further, a comparison can only be made if the estimated value also 'ignores individual circumstances.'
While the TVC concept is sound, running the numbers practically can produce some ludicrous numbers and discounting at this lower rate artificially increases the TVC figure. Presenting somebody with a huge number representing the value of staying in the scheme is certainly not the way to help clients understand their choice.
You would expect consistent growth in invested assets for the next five to 20 years, but the FCA don’t see it that way from the perspective of your DB pensions. They say you are taking virtually no investment risk as a DB member, which should, of course, be reflected in the information given, but should not be interpreted in a way that sways a decision. When a member is getting their cash equivalent transfer value (CETV), they are not given the context of the TVC that uses sensible assumptions.
The FCA made a mistake, and no wonder advisers have been dismissive of the TVC because of the calculation basis. While due prominence should be given to it, those considering a pension transfer should understand that it is a complicated representation of the value of the scheme and not an exact science, and the advice they receive from their adviser should take into account all aspects of why a transfer would or would not be suitable, personal circumstances and financial position.