In my inbox is a powerful statement from a steel-worker in Port Talbot who has suggestions about how transfers from defined benefit schemes are conducted.
It asks a fundamental question, if we are seeing such a number of such transfers, why is there not a single way of doing things? Why is it all so complicated?
I have just finished reading the technical note for advisers – outlining the basis for transfers for BSPS2 benefits.
It stops short of saying that the transfers for BSPS2 will be lower than for the old scheme (which ceases to be on March 29th). We must get used to calling BSPS2 the New British Steel Pension Scheme.
But it is a very complicated document and reinforces the need for expert advice – not least to help ordinary people know what is going on.
Valuing your defined benefit rights
It is as natural to under-value a pension as it is to over-value a cash sum. The bias is behavioural and you don’t have to be a behavioural economist to work out why £1,000,000 is more enticing that £25,000 pa increasing by CPI.
Since the cash equivalence of pension rights is subject to so many obscure factors. Here is Willis Tower’s Watson’s (excellent explanation in its preamble)
The following is a simplified description of the method used to calculate a member’s CETV:
1. The benefits that are due to the member at their Normal Retirement Age are estimated. In most cases this will include an estimate of the annual increases that will apply to the deferred pension each year until the member’s Normal Retirement Age, based upon unknown levels of future inflation.
2. The estimated cost of paying the benefits at and after Normal Retirement Age is then assessed. This calculation considers how the payments are expected to increase each year (often based upon unknown levels of inflation), how long the pension is expected to be paid for (based upon how long the member is likely to live after retirement), an estimate of the amount of spouses pension payments to be made after the death of the member, and how long the spouse’s pension is expected to be paid for.
3. The estimated cost is adjusted to allow for the fact that the assets held by the Scheme are expected to increase each year with investment returns, and that these investment returns can be used to help pay for the member’s benefits in future.
The CETV calculation makes a number of assumptions about the future, including future expectations of investment returns on the Scheme’s assets, expectations of future inflation, and expectations of life expectancy.
It goes without saying that WTW are using scheme specific mortality and the very latest CPI tables, that the future expectations of investment returns are subject to expert analysis and the scrutiny of likely future inflation is flawless. Nonetheless, WTW admit that the CETV itself is no more than a guess.
Assessing the value of a CETV
Since the CETV itself is a “good guess” and the judgement of most people offered a CETV – subject to the bias’ in favour of cash, the job of an adviser is to encourage confidence in rational decision making, not to pander to prejudice. This is where so much advice I have seen has failed.
Since the reward for advisers is also biased towards the taking of the transfer, where the adviser is paid for the investment , management and drawdown of the proceeds, there is an almost unassailable drift towards transfer. Indeed, we have seen members of BSPS who simply take their Transfer analysis from one adviser to another till they find one who sill accept them as an insistent customer or find a good reason to reject the advice to stay put,
The value of a CETV, despite the FCAs repeated warning that it is typically less valuable than the defined benefit, seems simply irresistible.
What is to be done
My suggestions about how we resist the irresistible are outlined in my Five Christmas Crackers blog
- Full disclosure of all transfer costs and cost of ongoing advice to include an estimate of exit penalties from fund management and/or advisory contracts.
- Independent sign-off from a second IFA where total cost of transfer exceeds 2% or £2,000.
- Banning of all marketing expenses paid from funds to third parties for provision of services (e.g. lead generation). Lead generation costs to be explicitly stated where total cost exceeds 2% or £2000
- Transfer analysis and advice certificate to be paid for prior to request for funds and not charged conditional on transfer transaction completing.
- Advisers engaging in this business to submit fee model to FCA prior to annual authorisation. Re-authorisation subject to inspection of previous year’s business, cost of PTS to be calculated by FCA to include this extra regulatory burden.
The remedies demanded by my friend the steel worker are more fundamental. I think our proposals aren’t mutually exclusive.
What we agree on for sure is that SOMETHING MUST BE DONE!
Agreed
To the list we must add;
All scheme administrators to provide full details of the assumptions they use (in other words full details of the transfer value calculation methodology) and details of the circumstances where the assumptions change
Nick, the sooner we can agree a common template for reporting the better. Frankly I think this is more urgent than the work being done on data standards for the dashboard, but maybe I’m biased!
Your attack on pension transfers, Henry, reflects (I suspect) a personal bias to paternalism rather libertarianism, a divide which can prove difficult to bridge even with reasoned argument. But I would like to have a go, being on the side of personal freedom and by instinct and experience deeply mistrustful in financial services of paternalist institutions, regulations and product constructs. Transfers are a special case of a general freedom to manage one’s own retirement income and spending. Even this larger opportunity is still in the early stages of development. Technical solutions are only emerging slowly (in an industry notable for its lack of openness to technology). But as long as the opportunity exists, solutions will emerge and competition between them should ensure the best thrive. So will scammers emerge, but they can be dealt with without halting the opportunity for all.
I like to start with what I am in this job to do. Our function, or calling, when we work as advisers/consultants/actuaries in an institutional or private context, is to help clients identify their true utility and then to help them make the choices that can maximise that utility. It’s not a dependent relationship unless we are specifically working as fiduciaries for clients incapable (through age or mental health) of making choices for themselves. Halting transfers means depriving individuals of the opportunity to improve their welfare, in contradiction of our function.
It is also a counsel of despair, in the sense that it assumes there aren’t solutions to the problem of informing rational decision making by, say, a man who has only ever worked in a blast furnace as man and boy and has limited (or even bad) experience of living with the volatility of savings held in the form of market-priced financial assets and whose only capital is a house worth (in all probability) a fraction of the value of their pension. It’s hard to think of a personal situation in which a transfer would not be, on paper, more transformative, even if not, idiosyncratically, the preferred option in fact.
This is depressing because it is essentially a technical problem and it is well within the scope of actuarial and investment professionals to solve it. I don’t disagree much with your definition of the problem or with the need for the solution to be unbiased (by business models or agency interests) and (perhaps even) self-selecting once utility has been identified accurately. The best form of selection is one informed by the impacts of a complete set of options to which the selector (not an agent) applies consideration of personal consequences (which only they can envisage). In such a process, what defines personal utility, what their preferences are between different sources of risk and the most appropriate approaches to managing or laying off those risks all emerge jointly from the selection process itself – because these are all attributes that differentiate the options. There is no ‘recommendation’ as such when the advice process relies on informed self selection.
The question we as professionals should be focusing on is what informs that self selection in the case of a choice between a DB pension and a DC pension given a known CETV. This is exactly the same question that the FCA needed to ask itself when revisiting the current highly-prescriptive advice process. It recognised (arguably somewhat belatedly) that the current process does not permit a like-for-like quantification of sustainable real income or spending power (because it relies on time-independent growth rates and their deviations rather than time-specific income levels – on drivers but not outcomes). This is what leaves people vulnerable (as you rightly point out) to cognitive dissonance (not resisting the resistible) when comparing a capital sum with an income stream.
The FCA has two suggestions for solving this problem, neither of which is above criticism. We are still waiting for feedback from the consultation. The first was a comparison of capital values. This is deeply flawed (just as the current critical yield is flawed) because it assumes an annuity purchase at NRA as the means of securing the income and so is not a comparison of outcomes between a secure income at every stage and an income stream subject to economic risks at every stage. Worse, it validates an inconsistent attitude to risk pre and at retirement which, by the standards of the FCA’s general suitability guidance, logically constitutes non-compliant advice!
The best hope for informed self-selection is a quantification of the outcomes, i.e. the possible income levels when these are constrained to be subject to i) sustainability without unplanned cuts, ii) self-insurance of the longevity risk (i.e. the capital must last to age 95, say) and iii) inflation protection (not all elements of the DB pension necessarily being fully protected from inflation). Though outcomes are the product of growth rates and their deviations plus inflation and its deviations (perhaps conflated as directly-observable real-return trends and risks), the FCA recognises that the best tools for modelling outcomes are probably stochastic. It is difficult otherwise to quantify the probability distribution for income at different stages or ages when both the expected returns and the risks are horizon-dependent and also (once draw has started) path-dependent. The FCA has also suggested that non-investment return factors be quantified in a way consistent with either the capital value or the income stream. An example is that differences in the spouse pension can be quantified by applying an an annual insurance cost to the DB income stream to secure the same benefits as the DC pension. Finally, the FCA has recognised that the comparison has to be holistic, taking into account other resources (in or out of pension accounts). This stops at stating the obvious fact that there may be other sources of capital able to contribute to funding retirement spending. It needs the insight that the optimal solution may be a combination of the DB income and an altered approach to own funds – or even (in the case of a transfer) that the combined capital ought not to be managed the same way as existing capital if the latter took into account the underpinning of a risk-free income stream which is about to disappear. All of these are technical improvements that the industry itself could easily accept and extend.
I too quote Bill Sharpe’s remark about drawdown being one of the most complex of tasks
he has encountered in finance. But his was not a counsel of despair. At the time, he was launching one of the first services (Financial Engines in the USA) to support informed self-selection in DC pensions using stochastic modelling. I quote him as a reminder of how valuable is a solution to this problem – the problem being both complex and mission critical.
Taking as an example the Fowler Drew stochastic model and applying it to the situation of a 50-year old BSPS member, we can quantify the income comparison. For a CETV representing 25 times current uplifted benefit, 96% of the distribution of potential income (planned to last till age 95) lies above the DB income, even with a low level of risk tolerance. (The underlying investments, consistent with an LDI approach, are dynamically-managed combinations of cash/ILGs and equities and the total cost assumption is 1% pa.). This measures the difference dependent on investment returns alone. But in this case it is likely that the DB target is itself subject to inflation risk and that the spouse pension difference should be quantified by allowing for an insurance premium, both of which improve the potential spending gain. The basis of comparison turned out not to be complicated in the case of a BSPS member by the need for a prior choice between the old scheme (entering the PPF) and the new scheme (and the choice in the event of not transferring also looked relatively simple as long as tax free cash was relevant).
Though the numbers imply a genuinely transformative difference in spending power, a transfer does of course also transform the experience of risk. The volatility of the market value of the DC assets providing the planned spending, though allowed for in the model, also needs to be lived with and so this too needs to be quantified and explained before a choice can be completely informed and fully costed. How an individual trades off the path risk and the outcomes is itself a form of directly exhibiting their utility and risk preferences without requiring a recommendation or interpretation by an agent and without agency biases.
There is something else depressing about professionals being anti-transfer. Though I’m not suggesting this applies to you, Henry, it can imply that they do not understand the exceptional nature and origin of the utility gain, or even ‘transformation’. It is lazy thinking to assume that a general rule, even one based on market theory, will always apply. This is not a ‘market’ phenomenon but an example of a utility gain created by external intervention. It was once generally true that there was no market-derived potential for gain, when the assets underpinning both personal and DB pensions were broadly similar (‘balanced’ asset allocations targeting standardised volatility not time-specific real outcomes) and so had similar expected risk-adjusted returns. This ceased to be the case with the onset of LDI in occupational schemes, and with regulations introducing real consequences for mark-to-market funding shortfalls. But the nail in the coffin was QE. Once derisking had widely occurred, it was negative ILG yields that meant the default assumption switched to being that drawdown was likely, rather than unlikely, to increase utility, by providing a distribution of possible sustainable real income, drawn from the CETV, most (or even in some cases, all) of which lies above the projected DB income.
Even the FCA has had to concede that this externality invalidates its past default assumption that a DC pension is less valuable, or offers less welfare, than a DB pension. (Your observation here, Henry, is out of date but it was for a long time the case.) There is less evidence that the FOS recognises this, however. And of course PI insurers have no idea and take their cue from uninformed commentators.
The option of an index-linked annuity has always been available to DC members but is routinely rejected because it is so expensive in terms of resources required. It is only pension regulation and international accounting that have ‘forced’ DB schemes to pay a price individuals reject. And it is pension regulation that obliges broadly the same price to be offered as a CETV. In other words, you get the payoffs of a risky strategy from the resources required of a riskless strategy.
I am happy to defend the reasoning (and indeed our own modelling) if anyone cares to challenge them in the excellent forum for debate you have created, Henry.