Earlier this year I wrote a blog “why some transfers are ridiculously high” which set out to explain how DB transfer values are calculated and why they are at present at historical highs.
My friend and colleague Alan Smith presented the actuarial version of that blog at the Great Pension Debate. I don’t think we distributed the slides, but if you want to see the technical arguments for high transfers, please read , download and share these slides, they are meant to help – not to sell us as actuaries!
I won’t be delivering these slides to an audience at the Pensions Network tomorrow, but I will be referring to them.
If you are going to the event in Tring, and have questions about this blog- please ask them at the session on Friday Sept 8th (tomorrow as I write)
Transfer values are a regular topic of breakfast discussion in our household.
I live with someone who manages a DB scheme with assets north of £45bn and with outflows from CETVs of some £250m a month. She reports that there are schemes in her peer group with even higher levels of exodus.
Her feeling and that of many senior pension professionals is not just that pension transfers are high – but that they may be “too high”.
The fundamental objection to the current means of calculating CETVs
One argument, an argument that Con Keating articulates, is that there is an unstated but implicit internal rate of return on which pension promises are made at the outset of someone’s joining a DB plan. This is not “time- variant” – it does not vary with time.
If you accept this argument of an internal rate of return, Con calls it the accrual rate, then all transfers would be calculated using this as the discount rate and transfer values would be much lower than they are today, reflecting the longer term assumptions underpinning the scheme, not the short-term best estimates discount rate – based on the scheme’s actual asset allocation a the time of transfer.
The pragmatic arguments against the current means of calculating CETVs
Another argument, based on a less fundamental approach to the problem, is that CETVs are unfairly rewarding those transferring with the prudence with which the trustees are managing the assets. Put in easier words, people are getting fair shares plus.
The highest transfers, those which give cash sums of 40+ times the pension being forsaken, are so high- typically because the remaining assets within the scheme have been selected to maximise the security to existing members – it could be argued that schemes that are invested almost entirely in bonds are “self-sufficient” and don’t need any future contributions from the sponsoring employer. Indeed most of such schemes want to sell themselves to insurance companies who will guarantee to pay the pensions.
Not only do members walk away with the “prudence” in the funding, they also get a CETV based on 100% of the benefits being paid as pension. In practice – most people take around 75% of the benefit as pension and the rest as tax-free-cash. As we all know, tax-free-cash commutation figures are set in favour of the scheme. Every time a CETV is paid out on the basis of 100% pension being paid, the scheme bleeds the cash-commutation windfall.
Transfer values from such schemes are close to the buy-out cost of the scheme. They don’t offer much of a discount to the employer to the book-cost of the liabilities in the company accounts (under IAS 19) and they offer individuals a right to something well in excess of the original promise – the transfer includes the price of the guarantee of the insurer (or a good part of it).
Why does this matter?
It could be argued that these super high CETVs are windfalls for those lucky enough to have them – rather like the huge bungs paid out when mutual demutualised. This argument simply says that some people get lucky.
But when some people get lucky, the premium they receive is paid by others. In the case of defined benefit schemes, the high transfer values are paid for at the expense of other stakeholders of the scheme.
One of those stakeholders may be the sponsor, who is relying on an investment strategy that benefits from a carefully planned cash-flow strategy that may have to be unwound to meet exceptional early payments of CETV. If you are paying out £3bn a year in CETVs against a fund of £45bn , you have to do a bit of rejigging, re-jigging does not come cheap. The cost of changing an investment strategy is born in the future funding rate of the scheme- that cost is either born solely by the employer or shared by those members still accruing. Either way there is a cost.
And if the point of moving the scheme into low-risk assets, was to immunise the sponsor from future cash calls, the impact of CETVs on the sponsor will be most unwelcome. The sponsor can rightly say they have paid once for prudence, why pay again to regain prudence that has been un-necessarily paid out in the CETVs. In extremis, the sponsor may walk away from the problem and that puts members in jeopardy of a scheme going into the PPF.
Is there a solution?
It’s not often that actuaries are challenged, least of all pension actuaries. But I am hearing stories of expert trustees challenging the payment of high transfer values on the grounds laid out above.
Of course, there are all kinds of reasons that employers like people taking transfers, but for trustees, they are not good reasons. Trustees want pensions to be paid and paid in full. They do not run pension schemes as a kind of launch pad for the wealth managers.
Nor do they run their pension schemes for the benefit of finance directors of sponsors who can write large chunks of pension liabilities from the sponsor’s balance sheets on the basis of what has happened in the past.
The Trustee solution may be as simple as challenging the basis of CETV transfer and going back to the first principles of how the scheme was set up. It is unlikely that they will adopt as radical a discount rate as Con Keating’s IRR or “accrual rate” but it is quite likely that they will argue that CETVs should not include the full prudence within the scheme funding and should reflect the commutation of tax-free cash.
If that challenge happens, and is successful, then the current transfer bonanza may be drawing to a close.
However – I do not suppose that this will happen soon and this is not a call for IFAs to put out the “transfer now while CETVs last” sign.
One final point – and it’s an important point. There is a much simpler way for trustees to reduce CETVs and that is to demand an insufficiency report which tells members that the Transfer Value has been reduced because the scheme is in deficit and the trustees need to protect the scheme as a whole. Those who remember market level adjusters in with-profits will see the analogy.
Trustees are understandably nervous about telling members they are nervous. It tends to cause a run on the scheme and give all the wrong signals to the Pensions Regulator.
Many people have commented that there are too few insufficiency reports out there. There are very few employers who make those arguments, it hardly does your credit rating good – if your trustees are telling all and sundry you may not afford the pension scheme.
It may be time for insufficiency reports to be reviewed by the Regulator, they aren’t doing what they are supposed to be doing and we may need something better.
I find myself once again having to talk about something which is sensitive and I’m quite sure that a lot of actuaries, including some of my colleagues, who will be asking why a non-actuary is asking questions about the way they do things.
Once again I will point such people to the rubric at the top right hand corner of this blog. I am speaking as a non-expert but as someone who cares about pensions.