“The first cut is the cheapest” – transferring legacy pensions

We all know the song. The revised phrase was coined by stockbrokers who’d tell their customers to sell out of a failing stock before it’s price fell again. The phrase use to be sung to Equitable Life policyholders who hung on to their with-profits policies as the values progressively worsened.

This blog is about transferring pensions from earlier employments – what are known as dormant pots. It deals first with the DWP’s recent paper on the matter and towards the end deals with the issue that the DWP didn’t, namely how to clean up the legacy.

My recommendation is that legacy pensions should be consolidated into more modern better managed pots, but before this happens we need the Pension Regulators to get their acts together and come up with a proper system to make sure policyholders get fair value from DC transfer values.

So though this is a long blog- it’s well worth reading to the end (Not that the rest aren’t)

The DWP have recently published high-level proposals to reduce the number of “dormant pension pots” we build up by finding a way of consolidating them into big pots. The paper can be read in full here and, as far as it goes, it makes sense.

The Government could have considered including the clearing system in place in Australia where individual’s can chose from a menu of pension schemes into which the employer is prepared to play via a central clearing house (I’ve written about this before -it has advantages as it provides a standard format for payroll – there being but one provider interface).

The DWP seem to have rejected this idea and I suspect they’ve done so as it would in time so undermine the link between a company and its pension scheme that (other than in a compulsory pension environment) it would do more harm than good.

The DWP have however decided that if there’s going to be consolidation, it should be around employer schemes and are proposing a system where your previous pot is automatically transferred into your new employer’s scheme. This makes sense to me with the obvious proviso that the transfer process does not leak a high percentage of the pot. Since we are unclear about the efficiency of DC transfers – this is a very real question and makes it all the more important that there is full transparency about what is meant by a “free switch”.

The Government have decided to leave out of this consolidation process what they refer to as legacy pensions – they cite as the reason , difficulties with pensions that provide “preferential annuity terms – eg Guaranteed Annuity Rates”. I suspect that the DWP are unsure just what is going on with transfer values from legacy DC pots and have put this issue in the “too hard” shoebox.

They’ve agreed in principle to the idea of “virtual aggregation” one I and my company argued for, where people are able to track their legacy pots via the development of a massive register which allows you to “search for my pensions” using your NI number as an identifier. This is a sensible solution to an intractable problem.

The DWP’s measures are designed to be “non-advised” – e.g. they happen automatically and are presumably going to be funded by some development pot either created by a levy or from the DWP (eg the taxpayer’s ) resources. There is a detailed cost-benefit analysis that accompanies the paper that looks at the cost-effectiveness of the various measures in more detail – I leave it to the DWP to work out how this is best funded though I hope they can do things rather more efficiently than the build of NEST (now costing us £172m and rising).

Which leaves one question unanswered what should we be “advised” to do with our small pension pots. The question of DB and hybrid pots (eg those that have guarantees from GMP to with-profits to guaranteed annuity rates) is too hard to call. The cost of working out the value of those guarantees simply can’t be justified on an individual basis (we have trouble cost-justifying the price of wholesale advice to trustees purchasing in bulk). These pots are going to have to lie dormant for the meanwhile.

The issue – and the meat of today’s blog – relates to the advised transfer of legacy DC pots and this is where the Government and their various Regulators have a part to play which is not touched on in The DWP paper.

When you get a transfer value for a DC pension – typically a personal pension or its predecessor a section 226 RAP, the transfer value tends to be lower than the stated current value. The difference is the transfer penalty and is the amount the insurance company has to clawback from you to recover its expenses (principally commission paid out years ago to an adviser). The calculation of this penalty is a complex business and definitely falls within the dark arts of a pricing actuary. I am lead to believe, by the dark artists in question that there is more fudging and bodging in this space than anyone cares to admit to. The problems are many, the original transfer factors were created when inflation was high, expected fund returns were high, scrutiny low and probity not always what it should have been. The cynical among us may doubt much has changed with regards probity, but we do at least live in a world where insurers aim to “treat customers fairly” – if only to keep the FSA at arm’s length.

There may be no standard methodology to calculate these transfer penalties , but there is no reason that individuals should not be provided with an assurance that they are being treated fairly when they apply to move their legacy pot as a result of “advice”. Indeed the “adviser” needs the insurer to provide him with that assurance because there is no way that he can tell whether the transfer penalty properly reflects fair value.

If I was an adviser and I knew I was getting fair value on a transfer, I would normally recommend the transfer take place and take place to what I considered the individual’s best pension pot. The “best pension pot” would be one that was properly invested and the investments properly managed with due regard to my client’s planning horizons and financial circumstances.

If the Pension Regulator and the FSA got together, I reckon they could get the providers of legacy pensions to get their act together. (whether they are doing new business today -like Zurich or Standard Life , or simply running off an old book like Resolution or any of the other “Zombie” lifecos).

What they’d need these companies to do is to expose the methodology of their transfer process to actuarial scrutiny – principally the scrutiny of the Independent actuaries of the aforementioned Regulators. If they are given a clean bill of health, they get a kitemark on the transfer value and the adviser and receiving scheme get no liability for poor advice. No kitemark and the insurer would be named and shamed as not “treating the customers fairly” and be subject to the usual fines and embarrassments till it cleaned its act up.

The National Audit Office has just criticised the Pension Regulator for ineffective regulation, well here is a highly effective proposal which would be easy to police and easy to implement.

The result of kitemarking DC transfer values

  1. Lower numbers of dormant pots
  2. Better investment management of legacy monies
  3. Bigger DC pots, easier to annuitise
  4. Greater inefficiencies in terms of policy charges.

This is such a good idea that I’d not be surprised to see it getting cross-party support and me getting the usual tPR DC OBE!

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
This entry was posted in actuaries, annuity, auto-enrolment, Change, dc pensions, defined aspiration, pension playpen, pensions, Personal Accounts, Retirement and tagged , , , , , , , . Bookmark the permalink.

15 Responses to “The first cut is the cheapest” – transferring legacy pensions

  1. Steve Brice says:

    I seem to remember teh introduction of a pension arrangement that collected contributions based on earnings and automatically amalgamated small pots together ready to use at retirement wasn’t ot called SERP’s or S2P or something?
    Still it is good to hear that the government is going to spend some of our taxpayers money reinventing a system which seemed to do what it was asked to do. Maybe some investment in a system that provides a better value for money annuity for tose accumulated pots might have been the way forward!
    Come up with a solution to poor annuity rates and there is your DC OBE!

  2. henry tapper says:

    Very good Steve and yes of course you’re right and Barbara Castle is still weeping.

    We have to make do with second best as a result.

    As regards annuities, the state could of course take back all this money and exchange it for enhanced BSP even now- if the idea of “risk-sharing” was to include other generations of tax-payers but that seems quite unacceptable.

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