Of all the pension freedoms, the freedom to take a cash equivalent transfer value (CETV) from a defined benefit scheme came first and has done most damage to the pensions system
Introduced by Norman Fowler in 1987 alongside the personal pension, it was supposed to give people the freedom to manage their own financial affairs in later life rather than be beholden to the rules of a pension scheme.
On the face of it a CETV is a fair exchange (as the Financial Reporting Council put it)
It is a fundamental requirement, stemming from the legislation, that a cash equivalent should represent the actuarial value of the corresponding accrued benefits. Such actuarial value should represent the expected cost within the scheme of providing such benefits and should be assessed having regard to market rates of return on equities, gilts or other assets as appropriate.
But in practice the philosophical principle of “choice” has been at war with the pragmatic demands of “need” for well over 30 years. As my friend Andrew Young pointed out yesterday.
We don’t need DB transfers.
— andrew young (@glesgabrighton) July 18, 2019
In this note I’m going to argue that we don’t need the choice of pension transfers on three grounds
- The choice is a moral hazard
- Taking CETVs has done individuals little good and sometimes much harm
- CETVs have undermined the principle of the second pillar pension in the UK
CETVs are a moral hazard
There are many choices which are denied to us. We cannot build what we like on land we own, we can’t sell shares in a closed period and people in unfunded DB schemes can’t take CETVs. The reasons given for denying these freedoms is that their exercise would not be in the public interest.
It’s interesting that transfers out of unfunded public sector schemes are against the public interest, while transfers out of private schemes are. The only difference to me is that with unfunded public schemes, there is no immediate cash pot to call on. The Treasury’s default position is that a pension can only be swapped for a cash sum when it doesn’t harm public finance cashflows.
I haven’t seen this argued elsewhere, but I think the point valid. There is a fundamental flaw here in HMT’s moral position. The architect of the pension freedoms are only prepared to offer them when it suits their cashflows.
For we see , instance after instance where the taking of a CETV accelerates the collection of tax-free revenue from the precipitous encashment of transferred money into bank accounts triggering immediate tax-bills.
The use of CETVs as a means for individuals to bring forward in retirement spending by cashing out pension money into bank accounts creates a moral hazard against the public interest. For it risks leaving the “early spenders” destitute in later life (with all the implications on the NHS, social care and on families that that involves).
Arguments from Government (which usually emenate from the Treasury) about the need for choice are flawed both in principle and in practice. There is no intellectual coherence in these arguments, they are based on unhealthy pragmatism that could best be described as “opportunistic”
2. Taking CETVs has done more harm than good
We now have over 30 years of evidence of the impact of CETVs.
Notoriously, most of the early CETVs taken, were subject to a pension review introduced in 1994 by the then industry regulator. This led to a huge restitution exercise that cost insurance companies and some advisers a great deal of money to return many who had transferred ill-advisedly to where they were.
Following this review it has become progressively harder to advise people to take a transfer (in terms of process). However the incentive to advise to transfer has massively increased as interest rates have reduced, pension schemes de-risked and transfer values grown. The cash equivalent for a £25,000 pa pension promise can now exceed £1m.
Unsurprisingly, people have started to think of pensions in terms of inheritable wealth and have been encouraged to do so by wealth managers who see the depletion of the pension pot as no good thing.
At the other extreme, we have vulnerable people transferring out of pension schemes thinking they can exploit investment opportunities including parking spaces in Dubai , holiday villas in Cape Verdi and cannabis farms everywhere.
In the middle are ordinary people who simply see the offer of CETVs as too good to miss out on. Many of these people have been caught up in mass migrations from DB schemes organised at times of financial stress by advisers with an eye to the main chance.
There are a relatively small number of transfers that have been taken to provide greater flexibility in retirement. The reasons for taking such transfers are argued in this well argued document produced by Sir Steve Webb and Royal London.
The even-handed approach advocated by Royal London focuses on the needs of those with the means to afford advice, leave pension money to the next of kin and with tax problems; in short the mass affluent. The worry is that many of those who consider themselves affluent in their later years of work, will find themselves anything but 30 years later.
The evidence that CETVs have done more good than harm is hard to find, evidence of the harm they are doing is only too easy to point to.
3. CETVs undermine pensions
The only reason for taking a CETV and reinvesting in a private annuity is that this would produce greater certainty than taking the promise of a scheme pension with the risk of reduction from insolvency (and the PPF).
The Ilford case specifically banned senior executives from taking CETVs when they knew their scheme (like Ilford’s) was heading for the PPF and allowed them to take benefits and run. In any event, actuaries who can see dark clouds ahead should be reducing CETVs through insufficiency reports.
Royal London’s “five reasons for taking a transfer value” includes a reason for transfer which concludes
…. if you think that your employer might not still be in business in a few years’ time and might leave the pension fund with a significant shortfall, it might be advantageous to consider moving the cash equivalent value of your current pension rights into a pension fund of your own.
This of course has been used on many occasions by financial advisors who can tap the prejudice of jaundiced employees and former employees against the sponsors of their pension schemes.
It is possible to argue that any employer might not have the capacity to meet its pension obligations. Trinity College Cambridge are currently arguing that there is sufficient risk of other colleges and universities failing that it should be leaving the USS.
The idea that you could be better off on your own than in your employer’s scheme assumes likely failure of your scheme sponsor and rubbish benefits from the USS. But the most pension schemes are currently investing to be sufficient of their employers and the transfer values of these schemes reflect the high levels of resilience of the scheme to the kinds of economic shock which would increase a pension deficit.
CETVs do not improve the funding position of pensions in the long-term, infact they reduce the value of the pension scheme as a utility to pay people second pillar pensions. The great economic advantage that Britain created for it by having second pillar pensions that paid proper wages in retirement is being swapped for a system that does no such thing.
Britain does not need CETVs!
We may like the idea of choice but when it comes to making choices , we are rubbish. Had we never had the choice of CETVs , I am with Andrew Young, we would have a better pension system, less harm to former pension scheme members and a Government less prone to creating moral hazard.
CETVs have made a lot of people in financial services rich. That is because the movement from institutional to retail pension management is almost always to the financial detriment of retail investors.
There are many other arguments that say that people should stay put in DB schemes and I am one of them, I not only am a DB pensioner – but I didn’t take my tax-free cash hoping I and my partner will live long enough to enjoy my pension in full.
I aspire to the health and vigour of Andy Young who is ten year’s my senior and hope all my readers will be approaching retirement with his good sense and erudition!