Counting on mortality

Transfers will still be difficult to justify in the short term, but this could change as mortality assumptions are updated says John Lawson, head of pensions at Standard Life

The process has taken more than three years, having started with the actuarial profession failing to agree a satisfactory solution in 2005. They asked the government to implement a statutory solution to the basis for calculating defined benefit transfer values for early leavers. Draft regulations were published in August 2007 and, after further consultation the final regulations emerged in April, and are due to come into force on October 1.

The government has made some changes to the draft but the substance of these regulations remains the same; trustees are responsible for the basis upon which transfer values are calculated. The regulations state that the cash equivalent should be calculated on an “actuarial basis” and should reflect the amount held within the scheme to provide for the member’s accrued benefits. This includes any options that might increase the value of the members’ benefits, and the value of any discretionary benefits where payment of such has become an established custom.

In determining the assumptions used in the calculation, the trustees must asess the economic, financial and demographic criteria, having taken advice from the scheme actuary. The discount rate used should reflect the scheme’s investment strategy. But will they result in fairer transfer values?

The typical experience of corporate advisers is that transfer values are insufficient when invested in a money purchase scheme, to match the value of the benefits given up. In many cases, the annualised return, or critical yield, required is usually in double rather than single digits. With a future inflation rate of 4 per cent or less, long-run rates of return, even from equities, are unlikely to exceed 10 per cent. This means that advisers are unlikely to recommend that their clients proceed with a transfer except in odd cases. For example, where the member is in poor health and improved death benefits result from a transfer to a personal pension.

At the moment, transfer values are calculated by the scheme actuary with reference to actuarial guidance note 11 (GN11). But in shifting responsibility to the trustees, the outcome is unlikely to differ significantly from today. Trustees will still seek advice from actuaries, and actuaries are unlikely to have changed their views just because the trustee now carries the can rather than them directly.

If transfer values continue to require double digit rates of return to match the value of the benefits surrendered, and transfer values are a fair reflection of the amount held to provide the benefits (as required by these regulations), that suggests schemes are also relying on what look like unachievable rates of return in order to pay the promised benefits.

While many schemes are said to be back in surplus, that assertion should be taken with a bucketful of salt. Other reports have disclosed that defined benefit schemes use a wide range of rates of expected return on equities and that longevity is underestimated. The Lane Clark and Peacock Accounting for Pensions 2007 survey shows that the most frequent life expectancy assumption is for current male pensioners to die in the range 83 to 85.

Compare that to the age 88 to 90 that insurers use for the expected lifespan of male annuitants and you realise that something is amiss.

However, if defined benefit schemes were to make more realistic mortality assumptions, those surpluses would quickly become deficits.

So, realistic assumptions are unlikely to happen overnight, but the Pensions Regulator is now beginning to push schemes in that direction.

Transfer values will not improve in the short-term but, if the regulator continues to turn the scheme funding screw, the amounts offered should gradually increase.

Defined benefit schemes and their sponsoring employers are therefore likely to continue offering inducements to deferred members to transfer out. HMRC effectively killed off cash-in-hand payments in January 2007 when it announced that these would be subject to both income tax and national insurance. But increasing the transfer value is still a realistic option and is allowed for under these new regulations.

Ex-members cannot reach their own conclusion about whether the offer on the table is good value or not, because complex considerations are involved. Financial advice will therefore be necessary and advisers who become aware of any scheme paying inducements should offer their services to the trustees.