A cash equivalent transfer value (CETV) is a right of anyone in a defined benefit pension scheme. The following explanation is taken from the Pensions Regulator’s website.
A CETV represents the expected cost of providing the member’s benefits within the scheme.
In the case of defined benefits, the CETV is a value determined on actuarial principles, which requires assumptions to be made about the future course of events affecting the scheme and the member’s benefits.
The normal way of calculating a transfer value us a method based on a best estimate of the expected cost of providing the member’s benefits in the scheme
This is a best estimate of the amount of money needed at the effective date of the calculation which, if invested by the scheme, would be just sufficient to provide the benefits.
So the value of the CETV is based on an actuary’s best estimate of the cost of buying out your pension when he or she does the calculation and it’s based on the likely return you could expect from the scheme assets (net of charges).
Now have a look at this table
It shows the impact of valuing a scheme using the best estimate method (Blue) of a typical pension scheme. The purple line shows where a risk free investment return is being used . The risk free rate is valuing liabilities by discounting them at the gilt rate while the best estimate discounts liabilities at the rate of the return achieved by a typical pension scheme.
As you can see, the low risk purple route suggests something quite different from the best estimates route. This is because the cost of the bonds that provide certainty has gone through the roof and valuing liabilities with reference to the negative yields bonds produce is crazy
Negative bond yields make about as much sense as Trump’s wall. But many ppl accept such strange ideas nowadays. What’s going on?
— Ros Altmann (@rosaltmann) November 15, 2016
All this would be theoretical if schemes invested in real assets (as they used to), but invest in gilts to get “negative bond yields”. Amazingly, the best estimate for such schemes is the purple not the blue line- this is having a weird impact on some transfer values. Schemes that have de-risked are discounting liabilities using a risk-free best estimate and that is sending CETVs sky-high!
Why Pension Transfers are (too) high.
I wrote yesterday about a correspondent (Actuary#1) who is guiltily taking a transfer value out of a scheme where the transfer value is over 40 times the pension he is giving up. The Lifetime Allowance calculation for valuing defined benefits is less than half that (20 times). His CETV is more than twice as high as “normal”.
It won’t surprise you to hear that his scheme is almost totally invested in gilts.
Actuary #1 has a right to be guilty, the reason his transfer value is so high is because investment consultants like him have been advising schemes to load up on bonds through something called liability driven investment. Schemes even borrow money through the derivatives market to get more exposure to bonds.
For schemes that “de-risk” using LDI , the best estimates discount rate is the gilt rate- or something close to it called gilts +. I happen to know the discount rate for the scheme this guilty consultant is transferring from, it is Gilts +1 – or 2.4%. His ridiculous CETV is based on this ridiculous assumed return on the fund.
To use Ros Altmann’s analogy, this method for calculating Cash Equivalent Transfers makes as much sense as Trump’s wall.
Not all defined benefit schemes invest like this one . Some still invest in a mix of bonds and equities and have resisted the temptation to borrow to load up on bonds (LDI).
These schemes will have CETVs much lower, CETVS based on common sense and not on the logic of Trump’s Wall. But more and more defined benefit schemes are de-risking and they are the ones that are giving ridiculous transfer values.
It takes an actuary to tell you
Now I am confident in all this because actuaries don’t lie. The information I’ve got on this scheme is from an actuary (who has done his research)- Actuary #2
“My ridiculous TV is best estimate on their investment strategy.
They’ve derisked and it’s almost all in gilts”.
This confirms what I knew already – that these are artificial transfer values based on the logic of Trump’s Wall. Perhaps we should call them “post-truth” transfer values!
Here is the guilty admission of my original actuary- Actuary #1 ( a member of the same scheme as actuary #2)
I’ll be more than happy with that (£10k advice bill to IFA#1) if we get the 40x on offer. As you say from there I have a different worry but one I’m wanting to take on (managing his investment pot). The aggregate effect of too many transfers will of course place even more strain on the longer term viability of benefits that I do not see as “guaranteed” anymore
He may not be so happy to be paying £10k to IFA #2 , when he finds out that his fellow scheme member paid £2.5k for advice on his transfer from IFA #2, but as we are dealing here with confidential information – I will not be able to divulge names of IFAs to these two actuaries!
The guilty admission of actuary #1 can be read as follows
- This investment strategy (that I’m a party to) is going to bankrupt my scheme and lose future retirees “guarantees” – presumably when the scheme is driven into the PPF
- This investment strategy is creating a massive windfall for both actuaries by way of a super-enhanced transfer value – “ridiculous” to quote actuary #2.
- Grabbing the CETV at today’s “ridiculous”valuation is placing a strain on the scheme, the sponsor and potentially all other schemes – if the scheme goes into the PPF).
I’d add a fourth, Actuary #1has clearly got the negotiating skills of a dementing gibbon (but we could have guessed that from reading the FCA’s Asset Management Study).
Transfer now while negative bond yields last!
Provided you are in a defined benefits pension scheme which uses a gilts based investment strategy, you too will be eligible for a Brucey Bonus type windfall so long as interest rates remain low and bond yields remain negative.
But transfer now while stocks last. Pay your IFA his absurd fee and screw the scheme. After all , you are financially astute and the whazzocks who don’t know the name of the game have only themselves to blame when they see their pension benefits taking a hair-cut when the scheme goes into the PPF.
If you are reading this far, it is probably because you are one of the financial elite who allows this calamitous state of affairs to happen. You are both architect and (potentially) principal beneficiary of the destruction of the defined benefit schemes that you consult on.
Take to Gilt-Plated Lifeboat CETV now and leave the ship to go down. Meanwhile make sure in your day job to ensure that all your clients are leveraged into gilts. It’s only fair that your mates can get the Gilt Plated Lifeboat too!
It’s what the asymmetry of information is all about!
What does all this tell us?
The current mania for de-risking is having an unexpected consequence. It is making the transfer value so attractive that the richer members who can afford exorbitant advisory fees , are getting out with a massive bonus.
Meanwhile those who cannot pay the advisory fees and those who have no idea they are sitting on a pot of gold, are seeing the financial security of their remaining benefits being eroded.
The cost of their scheme to their employer is also increasing as a result of these ridiculous transfer values. That’s impacting wages and the contribution rate to pensions.
So this is a scandal where a small number of financially astute people are getting away with the swag and everyone else suffers.
Well not quite- the actuaries who are involved in this are guilt-ridden and what they are doing is perfectly legal and economically reasonable. Why shouldn’t they act in their own best interest?
What is not so good is that the conditions that enable all this to happen were created by the actuaries and investment consultants who are savvy enough to take advantage. Perhaps this matter should be added to the long list of conflicts that the FCA are currently preparing as they consider the referral of said investment consultants to the Competition and Markets Authority.
There’s something odd here.
Pension schemes are nearly all in deficit, so we’re told, yet at least some of them judging by the article here find it possible to pay generous transfer values at up to 40 times the value of the annual pension.
Surely many trustees should be holding back the flood tide with transfer value terms which are anything but generous? Oh, yes, but then I think before they may do that they have to pay their scheme actuary to do some valuation (aka an insufficiency report) which involves a fee, no doubt.
Really good article and of course the real irony is that these schemes are not de risking. All investments carry risk in the case of gilts it is that the returns will not provide sufficient to cover the liabilities. I wonder how much of the deficits schemes like BHS have is as a result of such strategies.
By the way I know there are some unscrupulous advisers out there but not all of us are like that. We charge a flat fee of £1000 for such an analysis. We also will not proceed with the transfer unless it is right for the client and have
recommended the client keeps his FB benefits in many instances where their circumstances and risk profile as well as the critical yield and hurdle rates were not suitable.
Many pay more than 40 times George. The more they de-risk the higher the deficits and the transfer values! There is no logic in this. As far a I know, actuaries get reasonably paid for establishing and implementing transfer value processes but the real money is made in the investment advice.
Thanks John – useful to know – I’ll be in touch.
I wonder how many advisers handling transfers then invest a significant proportion of the assets in bonds! The logic you explain very well, Henry, also demands an alternative to bonds to match early liabilities that, if invested in equities, could easily fall short of the DB pension. Any chance of avoiding a shortfall over the whole plan requires equity risk but not at every horizon. Traditional balanced management (using the bond weight to locate the portfolio on a risk spectrum) will merely replicate the error of treating conventional bonds as if risk free. Close to retirement it probably requires quite a lot of the transfer proceeds to be in cash at negative real yields.
By the way the cost and value of the transfer analysis (usually with third party software) is nothing compared with the value and price worth paying for the advice about (or management of) the drawdown.
Thanks Stuart; of course this problem was originally not a problem; back in the day when the time horizon of a pension fund was infinite (like some university endowments for instance), then bonds were only used to stabilise and the proper business of the fund was equity ownership. We are now planning on some definite horizon, typically our death! Of course the collective model could still work but assumes that the fund lives on for future generations – this is where the long-term holding of equities over bonds, makes sense.
The problem indeed surfaces because the time horizon of pensions was infinite, but now no longer is. Surely though, any “definite horizon” here is not the death of individuals being paid pensions, but rather the wholesale demise of final salary pensions themselves, brought about by successive government policies.
Some final salary folk may be taking to the lifeboats, and some actuaries and accountants may be helping them on board. But how wrong is this when it was the government that ran the ship into the iceberg and holed it below the waterline in the first place?
I would say that one of the problems with actuaries is not that they are guilt ridden but more that they are gilt-ridden. Where people are advised to transfer out it is largely because they do not want to ever privately buy the annuity they have just given up by transferring out of their defined benefits scheme. such people will usually have other forms of income elsewhere, not need the guaranteed benefits, have inheritance tax issues, have sources of cash available elsewhere, and have other ways of generating income from other investments. AS they are not dependant on the transfer value for income they can therefore take a very long term approach. If the transfer value is 40 times the income and if they can invest with a long term view, then it is actually often very sensible in such circumstances to take the transfer value and give up guaranteed income. As long as they invest the money in an appropriately constructed balanced range of assets, then a TV in excess of 40 times greater than the guaranteed income should be more than capable of producing inflation plus 2.5% per year. And of course if the objective is to pass on wealth to future generations they don’t need to provide the income they have given up since they have other ways of looking after their own income needs. I have had G60 since November 2002. Until 2015 I had only ever advised one transfer out of final salary schemes. Since long term gilt yields hit the floor however, there have been a sizeable minority of cases which have led to me advising to transfer out benefits. In every case where the transfer was advised it was the case that the client had no need for the guaranteed income provided by the scheme. Where an element of guaranteed income was required we advised using some of the fund to purchase an annuity, leaving the remainder for whatever other purposes suited the client, and of course with the appropriate balance of assets to help minimise the risk of inappropriate volatility. I am transferring out of my own deferred DB scheme this month, it is just the obvious and sensible thing to do.
Nicely put Brian – the gilt-ridden actuary should be a theme for 2017!
What does an actuary want for Christmas?
To be free of all gilt!
Very good!
It seems that your problem is with your actuaries not with IFAs. Although to be honest I could charge a man from the street £10k+ to advice and implement a DB pension transfer process I have charged a lot less a couple of actuaries, mainly because they have higher knowledge of the subject and it takes less to advice.
It is interesting what you are saying and I have realised that as well. On one side the actuaries advice the scheme to derisk and buy more LDI (Gilts, bonds etc) but when it is about their personal life, the language change “I want to fix the Gilt yields now and transfer out and invest in 60% in equity and equity like assets”. Why they do not give the same advice to the DB pension scheme?
As a financial planner I do not have this conflict (of interest). I have always explained that capitalism over the long term works and advised clients to invest a sensible portion in equities. Yes the ride is sometimes volatile, but the outcomes are most of the time better. There are obviously other risks as well like pound cost ravaging and life expectancy issues. But at this moment in time the discount used by these schemes in their CETVs makes it worthwile to take these risks in many cases.
My duty of care as a pension transfer specialist is towards the client who pays for my pension transfer report. I am afraid I am not the adviser for the DB scheme, but I can see this going against them.
I am thinking forward and another issue we are considering is getting together with a pension administrator and an actuary, add 12 members together and create a pension scheme, each member with his own pension pot. This will have some limitations on the benefits paid and on flexibility but will still present death benefits in a way that could be benefic for their children (but not as benefic as flexi-access drawdown). The main benefit will be to reduce the lifetime allowance charge, as a pension scheme’ pension is tested multiplying by 20.