Pensions World

Schemes must be very careful when dangling the carrot of enhanced transfer values in front of members warns Martin Palmer, Friends Life

Since their inception, enhanced transfer values (or ETVs) have caused somewhat of a furore in the industry. Controversial because of the suggestion that they can exploit a lack of understanding of exactly what is being given up, ETVs – and the ways in which they are offered – remain one of the key ways to influence our industry’s credibility in the eyes of a sceptical and suspicious world.

Fair deal

There is a widespread recognition that final salary is a dying proposition and so trustees and managers of these pension arrangements have had to come up with appropriate strategies to deliver something of the promise made by their schemes through alternate routes. The transition towards the cost certainty offered by money purchase schemes is a reasonably simple case to make for future contributions, but in many cases final salary schemes have to work out what to do with the benefits accrued up to the point of the transition. Various de-risking strategies can be adopted, but there are no guarantees that liabilities will not continue to grow. With uncertain investment returns and seemingly endless increases in longevity assumptions, the perception of some finance directors is that they are throwing money into a “pensions black hole”.

The route to certain reductions in liability is to remove the promise of benefits from the scheme, to convert the final salary benefits into a cash equivalent transfer value (CETV) and offer to transfer this into a new money purchase scheme. Simple.

Except that the final salary scheme is rarely in a position to cover all of the benefits promised. The CETV offered can often be below the standard required to provide the same level of benefit in a defined contribution scheme.

Given that the equities market has been outperformed by cash over the past ten years, returns offered by even the most well-managed default funds in money purchase land seem to offer less to the member than the promise (note, not guarantee) from the final salary scheme and even the most cavalier investor is likely to think twice about trying to achieve year on year growth of 9% or more as the risk is simply not acceptable.

To get over this, schemes that wish to encourage their members to make the transfer from final salary to money purchase do so by doing calculations and deciding what could be offered to make the transfer more attractive while still offering the quid pro quo of a saving and/or future cost certainty for the sponsoring employer. The starting point has to be that the CETV plus any enhancement represents a fair representation of the value of the final salary promise, that an investor with a balanced attitude to risk could match or exceed the value of the final salary benefits in a money purchase environment. At this point some exercises will stall as the amount of cash that the employer is required to provide proves to be a stumbling block. For others, the next decision is how to structure the offer to meet the often conflicting needs of the employer, the trustees or managers of the scheme, the members’ representatives (the unions) and the individual. In the bad old days of enhanced transfers this meant offering an enhancement as an increment to the CETV or as a cash sum. The cash incentives offered were as attractive as possible and were available to individuals who would agree to transfer to a personal pension.

The industry was and remains justifiably suspicious of this behaviour.

We know that jam today is more attractive to the average customer than jam tomorrow.

If they would just pay the incentive into their new money purchase arrangement, that would be something, but the experience of the industry is that to offer someone a bunch of unexpected cash just means that while you are explaining what is happening, they are in another place, working out what they are going to spend it on.

Thankfully, the market has matured since then, the Pensions Regulator and the Financial Services Authority have issued guidance over a period of years and Steve Webb (the Minister of State for Pensions) announced last year that employer funded advice will be made compulsory, although the due diligence of advisers and pensions providers means that Friends Life would be disappointed if a single exercise that did not offer this already were to be discovered.    

Cash incentives

What we are seeing is a steady move away from the cash incentive as the carrot to tempt people away from their final salary scheme at the cost of their pension in retirement. Where cash is available as part of the offer, it is made to look less attractive by being of lower value than the transfer enhancement being given up. Limits in percentage terms and in monetary amounts are being placed on the cash amount available so that the life changing amounts of yesteryear are no longer available. We are also seeing the sum that can be taken as cash being restricted to any excess left over after the CETV required to meet the critical yield which the adviser is comfortable with has been met.

The fact that employees will always receive advice and that a full transfer value assessment summary is carried out and considered alongside specific member information around attitude to risk and wider financial requirements provides everyone in the industry with comfort that members are making informed decisions. They may not be the decisions that you or I might take but then each member’s personal financial needs are different, which is why the advice is needed.

Essentially, this way of proceeding is honest and tells the member what they need to know.

The company has to make sure that its communications are clear and honest about why the offer is being made, if only to provide an insight into the strength of the sponsoring employer’s promise, a major consideration for those for whom the Pension Protection Fund (PPF) will provide only limited protection.

When we talk about governance, what we really have in mind is how we take account of the member’s potential risk as far as it is possible, practical and responsible to undertake. This means that offers should be structured to minimise the influence of cash and allow advisers a greater opportunity to influence behaviour through their advice process. Friends Life wants to see fewer people transferring against advice on an insistent client basis.

When it comes to advice, the adviser should be concerned only with the member’s interests. We know that an adviser who decides that higher critical yields are appropriate will cost the employer less in terms of the enhancements required, but the main considerations need to be the quality of the member advice and the capacity of the adviser to deliver it. If member outcomes are not the highest priority then CETVs have the potential to cast a shadow over the image of the industry and what may be seen as a short term gain for the employer could become a long term cost in terms of reputational damage.