Pensions swap shop

Holding onto a defined benefit pension plan at all costs has long been accepted thinking, but pension freedoms have made defined contribution schemes increasingly attractive. When and why should holders of defined benefit plans make the swap?
by Gill Wadsworth


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It’s been two years since retirees aged 55 or over have been able to spend their pension savings with impunity. Following then Chancellor George Osborne’s unexpected announcement that – subject to certain tax regulations and their pension product supporting the new flexibilities – members of defined contribution (DC) plans are free to take control of their retirement pots, hundreds of thousands of people have taken advantage. DC schemes – also known as money purchase – are workplace or personal pensions where the individual takes the investment risk.

Figures from HM Revenue & Customs published in April 2017 reveal 176,000 individuals took flexible payments from their pension in the first quarter of this year compared to 84,000 in the quarter immediately after freedom and choice came into force back in 2015.

Yet for defined benefit (DB) members, such emancipation was out of reach unless they took the controversial decision to swap their promised retirement income for the relative uncertainty of a DC plan, a self-invested personal pension (SIPP) or a standard personal pension. Unlike these other options, DB plans are only available in the workplace and are sponsored by the employer, who bears the investment risk and agrees to pay a set benefit at retirement. 

Research from consultant Xafinity shows the number of DB to DC transfers increased by 166% in the first three months of 2017 compared with the same period in 2016. New figures from insurance company Royal London, released in June 2017, show that the most common transfer value is between £250,000 to £500,000 – outstripping the average UK house price of £216,000.
Outdated adviceThe government insists that anyone transferring from DB to DC plans seeks independent financial advice. In June 2017, the FCA issued a consultation (CP17/16: Advising on pension transfers), due to close on 21 September 2017, which could see guidance updated to reflect the current savings regime.

The current FCA rules state: “When advising a retail client ... whether to transfer ... a firm should start by assuming that a transfer, conversion or opt-out will not be suitable.” The FCA goes on to say that advisers can only recommend a transfer if there is clear evidence that taking this route is ‘in the client’s best interests’.
The number of DB to DC transfers increased by 166% in the first three months of 2017 This seems sensible. Giving up the security of a DB plan – an irreversible decision – should not be taken lightly. DB schemes offer a promised income for life and part of the pension usually continues to be paid to a spouse on death. The member carries no investment risk and the benefits are based on final salary. It is no wonder they are described as gold-plated. By contrast, a defined contribution pension or a cash lump sum has no equivalent guarantees. It’s also worth noting that not all DC schemes have allowed members to exercise their pension freedoms and they, the members, have had to move to a SIPP or standard personal pension.
Reasons to transferHowever, the current FCA position does not reflect the myriad reasons why individuals may look at this option today. Its proposed changes include replacing the current transfer value analysis requirement with a comparison showing the value of the benefits being given up; introducing a rule to require all advice in this area to be provided as a personal recommendation, which fully reflects the client’s circumstances and provides a recommended course of action; and updating the guidance on assessing suitability when giving a personal recommendation.

This new position would acknowledge the benefits of transferring, which include:
  • Flexibility

    DB benefits can be very rigid. They are payable on a set date, paid at a fixed rate, with a particular pattern of survivor benefits. By contrast, taking a cash sum and investing it means savers can draw their money when they most need it in retirement. So, if you want to retire at 60 and live off your savings you can do this with a DC pension whereas you might have to wait until you’re 65 – or whatever the scheme’s retirement age is – if you stay in the DB scheme. If DB policyholders do want to take early retirement, they need to accept reduced benefits. DC flexibility also means income can be turned up, down, on or off to suit particular income needs or manage income tax.
  • Inheritance

    When you die, a DB plan dies with you unless you have a spouse, civil partner, or, in some circumstances, dependents. Transfer to a DC scheme and if you die before 75, the cash balance left behind can be received by your successors completely tax free. Even if you die over the age of 75, whoever inherits your pot only has to pay income tax in the usual way when they make withdrawals. If your successors do not draw on this inheritance then it can be passed on to subsequent generations.
  • Ongoing investment

    It is possible to grow your pension if you remain invested in the markets, possibly over a series of decades. If the money is invested well, the overall outcome may be better than staying in a DB scheme. In many cases, to achieve a pension pot large enough to buy an income for life of equal value to the DB pension foregone will require a relatively high rate of return, which in turn would imply taking a high degree of investment risk.
  • Risk of employer insolvency

    If your employer goes bust and the scheme moves to the Pension Protection Fund, the member will only receive 90% of their benefit. And, for those with the highest pension entitlements, the PPF applies a cap if you enter the fund below the scheme pension age. The standard cap in 2017/18 is £38,505.61, which equates to £34,655.05 when the 90% level is applied. The cap is reduced further if you start to draw your scheme pension early. Consequently, you may be better off taking a cash sum that can be invested, particularly if you are concerned about your employer’s finances.
  • Attractive transfer values

    DB schemes have been keener than ever to transfer members out of the scheme as liabilities – which are discounted using government bonds – have increased at a time of persistently low interest rates, although that may now be changing. Schemes offer increasingly generous transfer values, making them attractive, especially for high earners. Suppose you expect to live for 20 years and are giving up a pension of £250 a month or £3,000 a year. Over the next 20 years you would receive £3,000 times 20 or £60,000 in pension (excluding the effects of inflation). So if the DC scheme offers you a tax-free lump sum of more than £60,000 you could be getting a good deal.
Such generous incentives may change as interest rates start to rise.
Who should switch?Bob Gordon, pensions consultancy manager at Standard Life, who will be speaking about the latest developments in DB and DC pension schemes at this year’s CISI Annual Financial Planning Conference, says: “Most people, most of the time, will be best sticking with DB. It can give peace of mind that the bills will be paid in old age. 

“But for a significant minority of (predominantly wealthier) DB members, where paying the bills isn’t an issue and their focus is on tax management and legacy planning, flipping over into the new world of DC flexibility can give a better financial outcome for them and their loved ones than sticking with a large, but inflexible, DB pension. Advisers can’t ignore this.

What price freedom?
Relatively few, if any, in the pensions industry saw the freedom and choice regime on the horizon. Its surprise arrival meant some commentators were fearful that giving savers control of their retirement pots could lead to some rash spending decisions.

At first, figures suggested these fears were well founded. Full cash withdrawals remain the most popular choice for those using freedom and choice. Yet in reality the majority of those taking lump sums had relatively small pensions to cash in and rather than this being an ill-considered path, it makes sense for many advisers.

Steve Webb, director of policy at Royal London, says: “Advisers report that people are more interested in pension saving because it is now seen as more flexible. Small pension pots have been taken as cash which probably makes sense for most people, especially if they have other pension income.”   

Tilney’s head of retirement planning, Andy James, agrees freedom and choice has been a widely welcome development, but notes some savers make poor decisions when it comes to tax planning. “We’ve seen no horror stories but some people are paying more tax than they need to because they are taking out too much in one go.”

However, looking to the future Steve would like to see less not more caution if the industry is to avoid storing up trouble. He says: “Probably my biggest concern is actually excessive caution. People who think they should take money out of their pension pot and put it in a current account or perhaps a cash ISA with negative real returns.”

Advisers are also concerned that, given the FCA’s changes to transfer advice, independent advice may get a lot more expensive.

Jim Stevenson, pensions technical manager at IFA Ascot Lloyd, warns the FCA’s proposals are likely to increase the demands on qualified pension transfer specialists, who are now expected to be able to demonstrate relevant experience, up-to-date knowledge and the depth to which they review reports. “All of this can only increase the cost of advice provided to potential transferers,” he says.
“With demand for DB transfer advice overwhelming capacity, a key challenge for advisers is how to identify the right clients quickly. Time spent advising on DB transfers that have little prospect of going ahead is time that could be better spent. And no one wants to pay a fee to be told to do nothing. This is where an effective pre-advice triage process can pay real dividends.”

Steven Cameron, pensions director at insurer Aegon, agrees that, today, the flexibility afforded  by  the  government’s  pension  freedoms  is  one  of the main reasons for transferring out of DB schemes, whereas before the new rules, the main driver was attractive annuity rates. “When annuity rates were particularly generous, people used to transfer out of DB schemes in the hope of securing  a  higher retirement  income  through an annuity,” he explains.

In light of clients’ desire for flexibility, advisers need to explore wider objectives, such as choosing when to start taking an income, how to shape income year on year and leaving funds to loved ones, says Steven. 

Increasingly, inheritance tax (IHT) planning is also a key reason to transfer. People are understandably keen to avoid a 40% tax bill and since pensions do not qualify as part of an estate, they are a neat way to keep expenses down.

“Eighty per cent of transfers are because of IHT,” says Andy James, head of retirement planning at financial adviser Tilney. “If the member is not reliant on their DB scheme and can live off other assets that are subject to IHT it makes sense to leave the pension alone and only fall back on it if needed.”

It makes sense to deplete your IHT deductible savings, such as ISAs, first, leaving the pension to pass to your descendants untouched if you die before age 75, after which you pay income tax rather than IHT, Andy explains. Using pensions in this way is tax efficient. For example, if one partner dies before age 75 and they leave their pension invested, the surviving partner can draw an income of £11,500 completely tax free. If that pension had been converted into cash before death it would form part of the estate and be taxed at 40%.

Recommending a transfer as part of IHT planning is relatively straightforward for advisers since it returns to cold hard figures. In other cases, the client’s objectives are more subjective.
Difficult judgmentsBut this leaves the adviser to make a value judgment rather than one based on critical yield calculations.

In the absence of updated guidance from the FCA, advisers could find they are left open to compensation claims if the decision to transfer, while appearing right at the time, turns out to be a poor one further down the line. If the Pensions Ombudsman deems the transfer advice unsuitable, the adviser may face a fine and inevitable reputational damage. Failure to carry out the appropriate checks also leaves members vulnerable to scams and fraud.

This has led Steven to call on the FCA to define more clearly what constitutes ‘suitable advice’. He says: “The surge in demand for DB transfer advice means advisers need urgent regulatory clarity from the FCA to allow them to support clients to achieve their objectives in this complex area.”

Given the current lack of guidance, it is no surprise that advisers are worried about taking on transfer work. In a survey of 222 advisers conducted by Fidelity International in March this year, 70% say advising on transfers could form a greater part of advisory businesses in the future. However, of this group, 64% are worried about retrospective legislation and how this could impact on them in the future. Richard Parkin, head of pensions policy at Fidelity International, says: “Advisers need to be totally sure it is in the members’ best interests to transfer.”

Understanding their clients’ objectives and being sure that a transfer would meet those is crucial. This requires a detailed fact-finding mission. The FCA demands advisers make a comparison between the benefits likely to be paid under a DB scheme with safeguarded benefits and the benefits afforded by a personal pension scheme, stakeholder scheme or other pension scheme with flexible benefits.

When dealing with insistent clients, there are three key steps advisers must take: provide clear, suitable advice for the individual client; be clear with the client what the risks of the alternative course of action are; and show the client is acting against advice.

“It is a lot of work and the advisers’ final recommendation may not be what the client wants to hear,” says Richard.
New examUltimately advisers need to feel equipped to deal with the changing mood towards transfers and they need confidence in dealing with insistent clients. 

In response to a new education need, the CISI offers a level 6 Pension Transfers and Planning Advice (PTPA) exam that covers the FCA specialist exam standards for pension transfer specialist advice, in combination with other exams, pending FCA recognition. The first sitting will be in December 2017.

Transfers are no longer seen as such a controversial move; indeed in some cases it makes more sense to switch than stick. Yet advisers need more support in dealing with the new environment and ensuring that there are no regrets further down the line.

Bob Gordon, pensions consultancy manager at Standard Life, will discuss 'DB or DC? – managing demand more efficiently and safely' at the upcoming Financial Planning Annual Conference.

This article was originally published in the Q3 2017 print edition of The Review. The print edition is available to all members who opt in to receive it, except student members. All eligible members who would like to receive future editions in the post should log in to MyCISI, click on My Account/Communications and set their preference to 'Yes'.

Published: 24 Aug 2017
  • Financial Planning
  • The Review
  • Pensions
  • Financial Planning Conference 2017
  • financial planning

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