The nastiest, hardest problem in finance


John Ralfe

For all the emotion surrounding transfer values, it’s worth taking a step back and ask the simple question “should I stay or should I go”. In July, John Ralfe wrote what (for me) is still the best summary of the situation facing members of the British Steel Pension Scheme. If you have an FT account you can read it here.

I will quote the section where John talks about the value of retaining rights to a pension as it is as relevant for a BSPS member as for anyone else. It is an exceptional piece of writing.

Cashing in a defined benefit pension means giving up a guaranteed monthly income, increasing in line with inflation, usually from age 65 until you die, and half this amount for your surviving spouse.

Once the pension is cashed in, the decision cannot be reversed.

A final salary pension provides complex guarantees, including longevity — not running out of money, however long you live — and investment performance, as the monthly payout will continue regardless of investment returns.

The value of these guarantees to an individual member may be low if they are wealthy and their chances of running out of enough money are tiny, however long they and their spouse live.

But most people are not so wealthy and because their pension is a large part of their overall wealth, these pension guarantees are very valuable.

Make no mistake, how much to spend in retirement, so you don’t run out of money, is the most complex financial decision anyone has to make. Even Nobel prizewinner Bill Sharpe recently described it as “the nastiest, hardest problem in finance”.

Anyone looking at cashing in their pension now with high transfer values shouldn’t think they are making a financial-genius play on future real interest rates, future equity returns and their life expectancy. They especially shouldn’t be fooled into thinking they can rely on holding equities for the “long run” to replace their guaranteed pensions. The expected return from equities is not a loyalty bonus, but is just the reward for taking risk.

The nastiest hardest problem in finance is not something that I would wish upon myself (which is why I didn’t take my CETV). Nor is it something that I would entrust to anybody else, unless that person had the credentials to manage that nasty hard problem.

IFAs who take on advice about the payment of retirement income from an individual drawdown pot, are rightly charging a large amount to do so. This is a massive enterprise involving substantial risk transfers. An IFA charges high fees in recognition that they are taking on considerable risk. As John points out, equity investment is not a free lunch, no amount of cash flow planning can help with people living longer than expected, the perils of drawdown are numerous and obvious to pension experts.

That is why experts reckon that 85% of those with the option to transfer, would be best advised not to take it.  Where responsible IFAs will take on drawdown – is for the minority of people who fully understand the risks involved and are prepared to share them with an IFA in return for the payment of proper fees. Those people, to adapt Al Cunningham’s phrase, will always have special needs.

The trustee dilemma

Since the introduction of the right to a transfer value, trustees have had some control over the rate at which money flows out of a scheme through transfers. Transfers are calculated with reference to the discount rate on the assets of the scheme. A scheme with a long-time horizon will pay relatively high discount rate because it invests in riskier long-term assets. BSPS was such a scheme and the CETVs aren’t particularly high. Transfers out of  BSPS have historically  been low and this is one of the reasons. The trustees dilemma at BSPS is because of a special event.

By comparison, schemes with short horizons – schemes aiming to be bought out within a few years, will be investing in short-term low risk assets and their CETVs will be much higher. The trustee dilemma is that if CETVs become very attractive , then the scheme has cash-calls to pay the CETVs which mess up the trustee’s investment strategies. I know one large scheme CIO who is referred to as “cashpoint”.

There’s a third type of scheme which has long-term horizons but which has done what it has been told to do by the Pensions Regulator and the PRA and de-risked the scheme’s investments even though it has a long-term investment strategies. Typically these are financial institutions – mainly banks. Here the trustee dilemma is most acute, “why should they be paying away their prudence in the CETV?”

Whether by special event, the adoption of a buy-out strategy or the imposition of a strategy by external regulators, most trustees are now facing the dilemma of high levels of transfers making their pension promises redundant. While I can understand some trustees – those who are aiming for short-term buy out, feeling comfortable that their job is made easier by voluntary transfers, I suspect most fiduciaries are queasy about whether those taking their CETVs have special needs or are just wowed by big numbers.

What can trustees do?

Progressive consultancies are already recommending that trustees look closely at the special needs of members and see if these might not be met from within the scheme. This might mean offering “re-shaping” of scheme benefits so that members can have their own level of indexation/spouses benefits. These are  mentioned by John as standard features of a DB plan – but they were built into the scheme rules perhaps 50 years ago – have times moved on.

Another thing that trustees can do, is invest in financial education of staff so that people are aware that planning an income for life is the nastiest, hardest problem in finance. The point of such education is not to stop transfers, but to make people aware that CETVs are a risk transfer and that risk has to be factored into the decision. As an extension of this education – the provision of advice, where advice is really needed, is something that trustees can provide either directly or through the employer. There is free resource at hand (TPAS) and I’d urge trustees to better understand it by following this link.

A final thing that Trustees can do is to protect schemes through the use of insufficiency reports. Where a scheme is considered not to be fully funded, trustees can reduce CETVs to protect the scheme and remaining members. At the time John wrote his article, there was an insufficiency report on the BSPS which reduced CETVs by 8% (this has since been reduced to 5%). It has been commented on that too few schemes issue these reports, there is a feeling among some trustees (and employers) that they are an admission of failure. I would suggest they are a declaration of intent to keep schemes strong and therefore quite the opposite.

 Can employers be rid of these nasty hard problems?

The reason why most sponsors of our great schemes want as little to do with guaranteeing pensions is that they know how hard this is to do. They’d much rather us members did it for ourselves and have no problems with high take up of  CETVs. USS, Royal Mail and Tata are all trying to limit their exposure to these promises.

CETVs are a convenient sluice – to divert flows of liabilities away. In my opinion, not enough is being done in some schemes to make sure that people taking CETVs are aware they are signing up for the hardest problem in finance. Nor is there help for those who feel they have special needs, to manage this nasty problem. Whether BSPS trustees should have done more is only half the point, actually the surge in CETV applications and take up is because of Tata’s corporate actions which led to the RAA, BSPS2 and the default of the PPF.

Tata will continue to employ steelworkers well after the “Time to Choose” and the decisions taken by steelworkers in this quarter, will be proven to be good or bad over the decades to come. Tata must be aware that no matter what disclaimers are signed by members taking their CETVs, they will never achieve total separation from the outcomes.

The risk of these nasty hard problems do not go away, and the extent to which they are shared, has yet to be fully understood.

Gavin and Henry

For the lads at Taibach RFC


About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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4 Responses to The nastiest, hardest problem in finance

  1. HOWARD AIREY says:

    Good informative article, but with reference to the BS scheme most people who are transferring out are doing so due to the lack of index rises pre 1997. If this was reversed and a full CPI cap[maybe -1 percent] was introduced across the scheme,there would be very few transfers.This DB scheme for many members will actually reduce their income significantly in future years, after all it is inflation that is the real danger to pensioners incomes.

  2. John Mather says:

    I often come across statements such as “New Model Adviser” but no model another today
    “IFAs who take on advice about the payment of retirement income from an individual drawdown pot, are rightly charging a large amount to do so”

    But no idea of what a reasonable fee might be particularly when it is almost impossible to give worthwhile advice unless it is comprehensive and where the pension is only one element

    I see the major folly in silo investment based on some algorithms with little or no prospect of an ongoing advice process

    Some pundits should realise that advising individuals and advising funds can have conflicts of interest which encourage conformational bias

  3. The only circumstances I think taking the cash is advisable, are if you are a) Desperate for the funds (e.g., to finance an operation for a loved one), b)Very rich, or c) So poor that the difference may affect your survival or longevity.

    • HOWARD AIREY says:

      For deferred members like me who would like the flexibility to retire early, after doing the maths, it really is the best option to transfer out. I am 53, 15 years BS pension, 14 years local gov pension scheme plus another small pension. To make sweeping statements like the above isn’t good. There are many people for whom transferring out is the best option.

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