A delicate balancing act

Enhanced transfer value exercises can be expected at ever bigger pension funds. The challenge is to manage risk properly says James Phillipps

The number of firms looking to reduce their defined benefit pension liabilities by offering employees incentives to leave is expected to soar, as rising costs push full buyouts out of reach for many.

With the first FTSE 100 company having just completed an enhanced transfer value exercise, PricewaterhouseCoopers, which advised on the deal although would not say which company it was, predicts a third of sponsoring employers will follow suit.

Chris Massey, head of pensions risk transfer at PwC, says: “The market has been quite active for two or three years and is still active but for different reasons and motivations. We are now getting more engagements with bigger pension funds, which had, if anything, been watching and waiting.

“Now that the first FTSE 100 company has completed and paid out, we are working with several other FTSE 100 and FTSE 250 companies.”

The appeal to sponsoring employers is clear, with the combination of rising deficits and falling profits heightening the desire to reduce liabilities at a time when buyouts are priced at too high a premium for most companies to be able to afford.

This has of course had a knock-on effect on the cost of offering enhanced transfer values as scheme funding gaps have widened almost across the board.

However, Massey says that although a few, particularly smaller firms have put their plans on hold, these deals remain the cheapest way of reducing liabilities.

But the main barrier to household names carrying out enhanced transfer value exercises has actually been their concerns as to whether reputational risk can be managed.

The fears around brand damage are understandable, says Liz Kane, a corporate consultant at AWD Chase de Vere. She points out that people are sceptical about pensions in general, and if they are being offered an incentive to leave a scheme, they will naturally question their employers’ motives.

“The risk is that if you do not use a reputable IFA and fund it right, people will come back to you in a couple of years and complain. If you have 20,000 people involved in the exercise that would represent a massive problem,” she says.

Concern that members could lose out has sparked attention from both the Financial Services Authority and The Pensions Regulator. No doubt wary of the pension misselling scandal of the 1990s, the pair have published guidance over the past year outlining how transfer values should be calculated and insisting on the importance of members receiving individual advice.

“The cost per member has probably doubled over the last 12 months compared to doing it on a non-advised basis before,” Massey says. “But the input we have had from the FSA has set out a clear framework and made many companies more confident about proceeding.”

Despite this additional expense, Barnett Waddingham partner Paul Jayson says that a scheme can typically expect to knock 10 per cent off its future buyout costs.

He says that the key to a successful enhanced transfer value exercise is clearly to find the level of enhancement that is attractive to both the member and the scheme.

Jarrod Parker, employee benefits director at Alexander Forbes Financial Services, says that the benchmark has to be an amount over the normal transfer value that every IFA would say represents a generous offer. “If it is at a fair level, reputational risk falls away,” he says.

Parker says reaching this amount is a three-stage process. Firstly, the adviser has to conduct a feasibility study to ascertain whether the level of savings the sponsoring employer can make with the budget it has available will make the deal worthwhile. Secondly, extensive data analysis of the scheme is required to analyse how the budget can be used most cost-effectively before, finally, the exercise is targeted at the tier of employees that will give the most bang for buck.

He says this can be based on factors such as length of service, salary and age, but warns that employers have to be wary about discriminating against members based on their age or sex, for example.

The right offer presented in the right way can still enable certain types of member to be targeted effectively, however, but Parker says that is crucial to structure the deal correctly or the employer has incurred a significant cost for no benefit.

Jayson says a flat generous uplift, for example, may be more attractive to younger, less risk averse members given the recent stockmarket falls.

“They might perceive it as restoring their transfer value to where it was a year ago while enabling them to get into equities at a 30 per cent discount,” he says.

The notion of having control over their own investments, particularly with a lower critical yield, can make the offer very tempting.

On the flipside, young people are more adversely affected by the investment return discounted in the transfer value than older members, when the rate used is high.

John Lawson, head of pensions policy at Standard Life, says this factor, coupled with the growing attraction of more flexible retirement options can make it easier to incentivise older, higher-earning members to leave the scheme.

“A lot of senior people move out of DB schemes a year before retirement because they want greater flexibility and understand the advantages of income drawdown,” he says.

He points out that these include having a greater portion of their fund protected at death with the spouse or their estate receiving all of the pot subject to a 35 per cent tax charge. In contrast, most DB schemes only offer 50 per cent death benefits, Lawson says.

He adds that this tier of members is likely to be more willing to lock in their accrued benefits given the fact that they are often aware that they have more to lose if their sponsoring employer were to go under.

Structuring an enhanced transfer value exercise in such a way that a meaningful take-up by the right type of member is achieved is one thing. Deciding on how to pay for it can be another no less thorny issue.

Kane says offering cash inducements rather than enhancements to transfer values can increase the chances of reputational risk as individuals cannot necessarily be trusted to use the money wisely.

“We prefer that cash inducements are not involved as it makes the advisers job much more difficult,” she says. “They will influence people, which is generally why they are used, and run the risk of people being more likely to accept an offer even if their adviser has recommended them not to.”

Massey says that even when individuals accept enhancements to their transfer values and the money stays in the pension system the risk remains that people make poor investment decisions and end up complaining later. Someone who switched a year ago is likely to be rueing the fact.

Clearly, there are no easy answers and the decision to proceed can often be something of a balancing act both for the employer and the employee. But one thing looks certain and that is that with the buyout market all but frozen, increasing numbers of schemes will be considering the option.

This in turn is set to create a growing need for advice around the country, something that individual firms will struggle to meet on their own.

Advisers that consider co-operating with their peers could find the door opens to a profitable line of business where their input could also help do some good for the reputation of the pensions industry.

Best practice on advising scheme members

The Financial Services Authority’s warning last year that scheme members cannot be expected to make an informed choice without individual advice has already had a significant impact on the pension transfer market.

Many leading corporate advisers, including AWD Chase de Vere and Alexander Forbes will no longer participate in direct offer deals, insisting that advice must be tailored.

Liz Kane, a corporate consultant at AWD Chase de Vere, says her firm will provide advice to both the company and the individual but will employ independent actuaries to calculate the level of enhancements.

“Communication is very important and we will then have an input in the offer letter and provide one-to-one advice to the members,” she says.

Depending on the size of the firm and its budget, this will be partly done by post or over the ‘phone.

PricewaterhouseCoopers’ head of pension risk transfer Chris Massey, believes that group presentations are both cost-effective and the best way of presenting detailed information because many members would not read a weighty tome.

“Customised advice should then be given to each member based on their personal circumstances after the presentation. This would outline the offer and the IFA’s advice, and it can be much shorter so it is far more likely to be read carefully,” he says.

Opportunity knocks for corporate advisers

As the number of major employers carrying out enhanced pension transfers grows, so to will the opportunities for regional corporate advisers to band together and offer individual member advice to firms with national coverage.

Chris Massey, head of pensions risk transfer at Pricewaterhouse-Coopers, says the market is rapidly maturing but the number of advisers with the requisite expertise both within single firms is unlikely to be able to cope with the demand.

“The number of IFAs out there with the experience and proper processes in place is small and for large exercises spread across the country we will probably see advisers working together to advise members,” he says.

With many employee benefits consultants being purely focused on advising employees, John Lawson, head of pensions policy at Standard Life, also expects to see more partnerships with IFAs emerging.

“A lot of EBCs will advise the trustees and the company but are not authorised to give individual advice and will pay an IFA as part of the agreement. We are likely to see advice firms come together to advise members where companies have a huge workforce, particularly when it has a large geographic spread,” he adds.

The pensions protection fund dilemma

The furore around Royal Bank of Scotland chief executive Sir Fred Goodwin’s £703,000 pension pay-off serves as a timely reminder of the loss of benefits senior executives may face if their company falls into the Pension Protection Fund.

The PPF currently promises to pay non-pensioners up to 90 per cent of their promised pension up to a cap of £27,700.

Pension campaigner Ros Altmann points out that this is also reduced for each of year of early retirement taken.

“If Sir Fred had worked for a private sector company that failed, his pension arrangements would end up in the PPF and his payment would be reduced to around £20,000 a year,’ she notes.

This figure includes the potential loss of significant indexation. Once compensation is in payment, only the part that derives from pensionable service on or after 6 April, 1997 is subject to indexation in line with the Retail Price Index, albeit subject to a 2.5% cap.

In addition, the PPF reserves the right to “reduce compensation in extreme circumstances.”

With over £100bn wiped off the value of the PPF 7800 Index last year alone and the number of company failures expected to increase during the recession, this is a very real danger, according to Standard Life head of pensions policy John Lawson.

“The PPF chief executive Partha Dasgupta says the PPF has adequate funding for the foreseeable future but it has got to pay out compensation until people die,” he says. “If a lot of companies do go bust and the PPF starts to feel the pressure, it will have to either cut back pensions or raise levies. It is simply not the case that either defined benefit schemes or the PPF are absolutely secure.”