There has been much written recently about the potential pitfalls of so called ‘inducement exercises.’ Whilst some of the concerns are valid I believe that provided those participating take the time to understand the recent regulatory guidance and the roles of various parties in the process then the risks are lower and more manageable than they might appear at first glance.
I have been calling for greater clarity in this area for many months and was greatly encouraged that the Pension Regulator acted so promptly in issuing guidance in January 2007 which provides us all with a more certain framework in which to act. I believe that it was not an accident that this document focussed not only on the employer and members’ perspective but also provided guidance for trustees and financial advisers.
I believe that trustees, in conjunction with the Scheme Actuary, have a pivotal role to play in ensuring that any transfer value offered to members provides them with a reasonable financial option. Too many transfer bases are weak and offer members poor value for their benefits. The first step in avoiding a mis-selling scandal is for Scheme Actuaries to recommend fair value transfer values to their trustees. For underfunded schemes this will mean that the gap between the available transfer value and the full transfer will be starkly evident to members. It should also mean that employers can’t fund these exercises on the cheap – it has always been our view that certainty should carry a premium for the employer but that the current buy-out premium is a poor use of anybody’s capital.
I also find it inconceivable that the objective of putting the member in a position to make an informed choice about transfers from DB to DC could be achieved without the participation of a suitable qualified financial adviser. Employers acting without this IFA support carry significantly increased risk and one suspects higher likelihood of some form of mis-selling. The regulatory guidance understands the importance of IFAs to the process and emphasises that trustees should encourage the employer to meet the cost of this “in a way that does not compromise the independence of that advice.”
Ensuring that an IFA is paid a fair rate for their advice should allay some concerns about indirect benefits influencing their advice. Transparency is a crucial element of the whole process..
Additionally should any communication from the Company not comply with the regulatory guidance then the trustees are encouraged to seriously consider issuing their own announcement.
This means that there is quite clearly a significant role now for trustees to play in this process and they must ensure that they are suitably skilled to act and also that any conflicts of interest that may exist on the trustee board are clearly identified and addressed. It is clearly in a company’s interests that members only receive one agreed communication rather than one from the employer and another from the trustees as this is only likely to create confusion.
So bearing this in mind I believe that it is vital in creating the desired transparency and to mitigate the risks that all potential participants in these exercises is aware of their and the other participants responsibilities and come up with an agreed strategy.
It is important to remember that scheme members have a statutory right to a transfer value in lieu of their benefits. In recent years members have not exercised this right because transfer values have represented poor value, reflecting pension scheme deficits.
As noted above it is also important to remember that trustees set transfer values, not the employer. In reality most trustees currently are forced to reduce the transfer value from that which the Scheme Actuary (a statutory trustee appointment) believes represents fair value to the member. In the vast majority of cases this means that the employer is topping up the scheme to the “full” transfer value which the trustees independent adviser is certifying represents fair value to the members. Given this we also believe it is misleading to refer to “enhanced” transfer values when what members are actually being presented with is only their full fair transfer value which in most cases can’t be provided by the scheme due to funding deficits. In the ongoing debate about these exercises I have yet to have anyone explain to me why they object to employers making available to scheme members the full transfer value that the Scheme Actuary, an independent professional, believes represents fair value for their scheme benefits.
It is always open to a Company to offer genuinely “enhanced” transfer values beyond the full fair value level but this is less common in our experience. It is important to remember that this figure will be less than the full buy-out cost of the benefits on the open market but then no-one seems to seriously argue that transfers should reflect buy-out costs. Even the proposals aimed at strengthening transfer values issued by the Actuarial profession stopped well short of this.
So primary responsibility for ensuring people receive fair transfer values rests with the trustees in conjunction with the Scheme Actuary. So how do members ensure this primary responsibility has been fulfilled?
A member needs to speak to an independent adviser who can properly analyse the transfer value offered, the benefits given up and any potential pro’s and con’s of proceeding to transfer based on the member’s individual circumstances. This view is explicitly supported by the recent regulatory guidance.
The Pensions Regulator also seems to understand the two basic principles which many usually astute observers seem determined to overlook:-
- Because the financial industry has for so long allowed the public to perceive financial advice as “free” (and therefore of no value), cost will be a barrier to members seeking appropriate advice.
- An IFAs contractual responsibility is to the individual he or she is advising, regardless of who picks up the tab for the advice.
From its guidance it is clear the Regulator sees no conflict between an IFA advising members but being paid by the Company. Indeed the Regulator actually supportive of this approach subject only to the caveat, as noted above, that it is provided “in a way that does not compromise the independence of that advice.”
The starting point then for an IFA to consider any TV is the critical yield (“CY”) – i.e. the annual return needed in the transferred arrangement to match the level of benefits offered by the scheme on a basis set by the FSA. This is only the starting point as the members individual circumstances and objectives need to be taken in to account. However, it is highly unlikely that a transfer will even be considered if the CY is not reasonable and any exercise run where the CY is high will be doomed to fail and will just prove a waste of resources for the employer. It is also extremely unlikely that any IFA, regardless of any potential incentive would be prepared to recommend a TV where it did not meet a suitable criteria. It would also seem sensible for the employer, prior to proceeding with any exercise to test what these critical yields might look like to ensure that it would be worthwhile committing the necessary resources.
A transfer option for employers is not the cheap option which many commentators to date have suggested. Poor value will inevitably lead to low take-up so there is an incentive to offer real value. This comes at a cost to the employer and when the cost of actuarial advice and professional financial advice is factored in, providing a transfer option is not a low cost solution. It does however provide members with choice, a chance to appraise their current pension provision with an industry expert and allows often beleaguered employers to place some certainty on final salary liabilities and potentially protect employment.
If employers attempt to offload liabilities using poor value transfers or without providing access to independent financial advice to ensure that members are in a position to make an informed choice, then the criticism seen to date may well be justified. Where members are given fair transfer values and access to high quality independent financial advice there is little reason why employers, trustees, individual members or even the Pensions Regulator would have concerns about the process. The potential for a win/win situation is significant.