Perverse incentives; Sexycash or prudent pension?

Posted on October 29, 2011 by henry tapper
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The problem we all face when we are asked to choose between cash or pension is very complicated. It is possible to put a cash price on a pound’s worth of pension but that’s just the beginning of the story.

Cash, as the Pension Minister told us at the recent NAPF conference is “sexy”, presumably pensions aren’t.

If you asked a cross section of the British public what a pound’s worth of level pension was worth to a healthy 65 year old male, I reckon you’d have a few guesses, one or two of them educated ….and you’d get a lot of blank looks.

What makes cash so sexy is it comes dressed in a big blousey fur coat. Cash is “tax-free” and “tax-free cash” is almost a pensions cliché. Cash soothes the savaged brow of the pensioner who knows it will pay tomorrow’s bills, this year’s holidays.  Cash suits the needs of those with low life expectancy and few dependents , cash suits those who know that there is a safety net when the cash is spent.

Which all suits those trying to keep the employer‘s future obligations to a minimum. Employers love it when the members of the  pension schemes they guarantee chose to take sexycash. They swap their uncertainty for a defined payment and though it might hurt the FD to see a big dollop of his pension assets being cased to get rid of the pension problem, he knows this is necessary pain which will be immediately rewarded.

 

As the Pension Regulator and now the Pension Minister are at pains to point out is that what’s good for the employer may not be in the best interests of the member. Since the member’s interests are protected by pension trustees, it is in the interest of employers to have trustees who don’t kick up a fuss and in the interests of members to have trustees who do.

This fundamental issue is so central to the governance of pension schemes that it’s worth some proper discussion. The issue that Steve Webb is banging on about is the use of sexycash to lure members out of company pensions. A much wider issue is whether it is in the interest of members to take the tax-free cash when they retire or just to take the pension. 

For now, the HMRC concession that allows the cash to be taken tax-free remains. We the tax-payers are subsidising  such a tilt in favour of cash-taking that many schemes are no longer bothering to offer fair value on the exchange of pension for cash kn owing that people will take tax-free cash- WHATEVER.

Both the sponsors and trustees of defined benefit pension schemes had better be careful here. If the Treasury identify the exploitation  of sexy tax-free cash as a loophole to de-risk Defined Benefits then they can apply the levers that close  the loophole.  There is plenty of scope for them to get their own back and it need not involve the end of tax-free cash- one of the great perks of a civil servant’s pension too.

 If you haven’t already been through Alan Higham’s brilliant analysis of the choice faced by those with deferred state pensions (cash or extra-pension), read it here.

Precisely this kind of analysis needs to be carried out by those facing the choice of cash  or pension at retirement. Indeed for many of us with multiple pensions both DB and DC , the question is even more complicated. Sometimes the cash that comes from DB plans can be sourced from DC pensions allowing members to avoid the penalties usually involved in swapping pension for cash mentioned above.

These decisions cannot be taken with the ready-reckoner software now available on the market . Don’t expect your friendly pension manager to provide you with a modelling tool that demonstrates how the actuarial factors governing your cash commutation are loaded against you and don’t expect your employer to advertise options to take DC AVCs as cash.

I’ve talked about the conflict of interest facing trustees, the need to keep the sponsor happy and the primary need to protect the member from being ripped off by practices like the  unscrupulous use of “sexycash”. These conflicts are particularly difficult when the employer and trustee are one (and this still happens with many smaller DB schemes).  The fact is that many DB  schemes are only technically solvent because it’s assumed that all members will, at retirement , take the tax-free cash. Trustees are therefore treading a very delicate line in recommending financial advice of the kind carried out by Alan which might recommend people exercise their right to take 100% pension.

It would be wrong of me to suggest that thorough financial advice at retirement is being stymied by trustees. There are many more obvious reasons. Financial advisers have been able to make money much more easily through doing other things, financial adviser’s understanding of the mathematical complexities has been limited and until recently occupational pension schemes did not have to sail as close to the wind as they do now. In short, Trustees had neither the need nor the resource to be proactive.

Should trustees be required to provide people with proper information on their choices at retirement. There is a strong fiduciary argument (that has yet to be tested int he courts) to suggest they have. However, a counter-argument that encouraging members to take pension over cash imperils the future viability of the scheme and could force it into the PPF. Trustees are hopelessly conflicted and these issues could be seen as the least of their problems,

Should employers be responsible for providing advice- well in as much as they have to pay the trustee’s bills and the trustees purchase advice for members then they are already on the hook but I can think of few employers who would voluntarily encourage members of their DB plans to keep unwanted risk in the scheme. The people who made the promises are rarely the people called on to keep them and the management teams of today’s sponsors are increasingly not even participating in the schemes as active members.  Employers seem neither obliged  or incentivized to help

The DWP have a public service obligation to make sure that people take sensible choices, not least because when pensions run out- people resort to state benefits. As Britain’s pension system moves ever further toward a compulsory contributory system, it looks as if the problems of perverse incentives will find themselves reverting to the tax-payer.

Ironically, Steve Webb may find it is cheaper and more effective to sort this problem through the improvement of public awareness of the issues than through draconian legislation or changes in the tax-treatment of pensions. That would be good news for Alan Higham and a sensible redeployment of many good financial advisers, who post the introduction of the Retail Distribution Review, may be wondering where future business many be coming from

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About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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