It’s a shame that Alistair Cunningham’s thought-piece on behavioural bias’ encouraging herds of us to “cash-out” our DB pensions, is behind a pay-wall.
If you are an FT subscriber you can use the link at the end of this article. If you aren’t you’ll have to make do with my synopsis and further thoughts.
It is concerning that the unscrupulous are meeting with the unwise, and the biases that we all share assist the worst possible outcomes, when most individuals should be leaving their final salary pensions untouched.
The article concerns itself with the difficulty of not taking a transfer value. It deals with the dynamics of the adviser/client relationship. The 100% year on year rise in CETV take-up (Xafinity consulting), is having a material impact on the way defined benefit schemes invest and their impact on corporate balance sheets.
One large pension scheme I have dealings with is reporting transfer requests at over £1bn a month, these are materially impacting not just the cash-flow planning of the scheme but its investment strategy. The potential “profit” from restating FRS120 liabilities after dispensing with CETVs on a “best estimate” basis, looks like a CFO windfall.
Put in lay-man’s terms. CETVs are calculated using a discount rate that reflects the actual asset allocation of the defined benefit schemes. Pensions are accounted for on company balance sheets using a discount rate based on corporate bond yields. Every CETV paid out will reduce scheme liabilities by more than the recognised cost of those liabilities on the balance sheet (unless the scheme is purely invested in bonds!).
We are hearing stories of employers who are not only booking historic gains but booking projected gains based on estimates of the CETV take up in 2017 and beyond. Some employers are booking these CETVs years in advance with whopping great financial windfalls appearing in the 2017 accounts.
Small wonder that we are hearing little from employers or their groups about the phenomenal increase in CETV activity.
The Trustee’s duty of care is to the member
The pension trustee’s duty of care is not to the employer but to the member. For all the talk of “integrated risk management” – this continues to be the case. If I can get the FT to all me to publish Alistair’s arguments in full, I will as they should be in trustee board packs throughout the year; but here they are in summary
Behavioural finance tells us that humans make decisions in ways that reflect their biases, and may not always operate with robot-like logic.
The prospect of poor decision-making is particularly prevalent in complex decisions, especially when they are made infrequently and are irreversible.
Transfer values have gone up in the last year. Individuals “anchor” – retaining recent values in mind, creating a bias towards transferring now.
People assume that falls in transfer values will represent a “missed opportunity” not a change in the costs of providing the defined benefit (pension).
Herd thinking is driving group-think, if it’s good for my colleague it is good for me. The traditional bias towards staying in a scheme can quickly be flipped.
There is a behavioural bias towards over-confidence, people make heroic assumptions about their investment returns while discounting the impact of future inflation.
Eight years into low inflation and an investment bull market, there’s a temptation for advisers to be complicit with this over-confidence, especially when they are the likely managers of the capital generated by the transfers. We are too used to real returns of 6% + over inflation to remember these are unusually high.
Alistair talks of availability bias, by which he means our fetish for freedom. The lure of a huge capital reservoir rather than a prescribed income stream is vivid and real. The reality of retirement is a drop in income to a floor of £155 p.w. (max). This is not so easy to visualise.
Add to these bias’ the “regret risk” of an irrevocable decision either to stay (and see CETVs fall with gilt rates) or leave (and see CETVs fall below return expectations) and the angst posed by consideration of the DB transfer option just grows!
Alistair also identifies risks surrounding a lack of pension education – especially among the well-educated professional classes. Pensions are different from other financial products, they need a lot of engagement; many professional clients allow their wider expertise to over-rule the need for personal due diligence – they take decisions instinctively and get pensions decisions wrong.
This is where confirmation bias kicks in, people who have a pre-determined instinct are saying “don’t convince me with the facts – my mind’s made up”. This can lead to an assumption – even when an adviser is against transferring – that “he would say that wouldn’t he”.
Finally Alistair points out that hindsight bias only ever works one way – to blame someone else when things go wrong! “You should have known” is such an easy phrase to throw at someone with deep pockets (or a liability insurance policy).
The momentum trade is hard to stop
The DB pension trustee is the guardian of a member’s best interests. But when the member is being presented with such an attractive offer as a CETV that tells him he will live for 40 or more years, the momentum to take the CETV can be unstoppable.
The DB pension trustee is not only arguing against all the behavioural bias’ that Alistair points out, but he’s arguing against the immediate interests of his sponsor (the employer). The reticence of the Pensions Regulator to get involved in this discussion has left such authorities as Ros Altmann to increase the momentum to switch.
Indeed , the former pensions minister was even found encouraging delegates at the latest DB conference to negotiate CETVs higher. Let’s be clear, the transfer value is not negotiable – its calculation is agreed by the trustees with help from the actuaries and should reflect the cost to the scheme of the liability given up. IT IS FORMULAIC. It is not to be challenged. ROS ALTMANN IS WRONG TO UNDERMINE THE TRUSTEE’s calculations, she is only adding to the confirmation bias’ that pre-exists in members minds and her encouragement to negotiate is deeply irresponsible.
There remains one further reason that CETV’s are challenged and this is not a challenge to the CETV. It is the deplorable practice among some high earners of seeking compensation from the scheme or employer, for the fiscal implications of taking a CETV,
For those who have pensions of up to £50,000 pa, there is no liability to a 55% pension taxation rate on their pension. But if you take a CETV of £1m + there is. A CETV calculated at 40 times the pension could see someone with a pension of £25,001 paying higher rate tax.
We are now hearing of employees approaching trustees and employers for compensation for breaching their lifetime allowance, because they have or will be taking their CETV.
If proof of the mad-house state of thinking among DB members is needed, that such a practice is even being talked about, is that proof.
You can read Alistair’s article in full from this link (if you are an FT subscriber)