The problem with defined benefit (DB) transfers can be boiled down to big numbers and small numbers.
Annual income of £40,000 could provide a transfer of £1 million or more, according to some indicative online calculators (notwithstanding tax and so on). But that £1 million comes with some investment risk for the pension holder that did not affect them in the scheme.
In the past, showing people the investment return they would need from that pot to support their income needs, the critical yield, was the main tool used to qualify the transfer offer. But the regulator has now gone further by introducing its own big number, representing what the cash value would be if it was left inside the scheme or, to put it another way, as if it were risk-free.
The transfer value comparator (TVC) is the tool it has created to generate these big numbers. And they are very big. Advisers say the TVC calculations are generating ‘huge numbers’, which are confusing to clients. Regulatory experts agree the figures can be a ‘big shock’ to clients and provide an ‘unfair comparison’.
Falling out of favour
To add to the oddness of it all, the regulator changed the basis for the TVC at the last minute to a method that would generate much bigger numbers, despite consulting on a different metric.
When the Financial Conduct Authority (FCA) first outlined the TVC, the concept was largely welcomed by advisers and compliance professionals alike.
Criticisms now largely centre on the calculation methodology and the FCA’s demand that it must be used as part of the advice process rather than kept to the triage stage. The TVC was proposed as a component of the appropriate pension transfer analysis (Apta) requirement. Apta replaces the previous transfer value analysis (TVAS) approach, which focused on the ‘critical yield’ required to match a guaranteed income.
The cash equivalent transfer value (CETV) offered by the DB scheme is shown as a chart alongside an estimated value needed to replace the client’s DB income in a defined contribution (DC) environment.
Gaming the system
In its policy statement, the FCA acknowledged a number of concerns from respondents to its previous consultation. Some had questioned the ‘partly generic and partly personalised’ nature of the TVC, and suggested a standardised approach to achieve greater clarity and reduce the likelihood of the comparator being ‘gamed’ by advisers using overoptimistic investment returns.
Importantly, the original consultation paper proposed that when working out the amount needed to reproduce safeguarded benefits firms should replace a required rate of growth with an appropriate discount rate. ‘This discount rate should be appropriate for each client,’ the FCA said, ‘based on their attitude to risk, irrespective of whether the proposed receiving scheme will involve flexi-access drawdown or an annuity.’
The FCA noted some respondents put forward the alternative to a discount rate appropriate to each client. The alternative suggested was a risk-free growth rate. The reasoning was it would allow a clearer comparison with the risk-free benefits being given up.
The FCA accepted the suggestion, and decided the risk-free rate would be determined from published gilt yields and dependent on the term until benefits become payable.
Gilty as charged?
This is where the main problems have arisen. Regulatory consultant and former FCA technical specialist Rory Percival (pictured above) explained: ‘It is an unfair comparison, because another way of perceiving the right hand column is that it is the cost of replacing the scheme benefits out in the open market, so if you did a transfer now and invested it, what pot would you need in the future to replace those benefits?
‘In which case, the discount rate should be investment returns relevant to the client’s risk profile, less the actual charges relevant to the investment. That discount basis was exactly the one that was proposed in the consultation paper, but the regulator decided not to do that; it went with the gilt rate.’
Why did the FCA change its mind?
The FCA said the purpose of the TVC is to ‘provide consumers with some context for the level of their transfer value to help them make an informed decision’.
It said: ‘There is usually no allowance for individual circumstances, such as marital status or a desire to take tax-free cash. This means a consistent comparison can only be provided if the estimated value also ignores individual circumstances.’
Adding, however, that: ‘We expect firms to take account of personal circumstances when preparing the Apta. We agree it would be inappropriate for the TVC to be the focus of the advice or a single rating factor in insurance premiums.’
In a lively discussion at the latest Great Pension Debate earlier this month, a panel of advisers bemoaned the calculation methodology.
David Penney (pictured above), director of London-based Penney, Ruddy & Winter, said he agreed with the concept of the TVC, until he tried to run one himself.
‘The figure was roughly double the CETV. I looked at the discount rate being used for this person, who was 54 years old, and after charges it was 0.89%,’ he said. ‘So that’s an assumption that someone will effectively invest for 12 years and get a return of 0.89%. That doubling of the number didn’t look right to me, and that was the first time I realised this risk-free concept had been introduced.’
Penney said the move would probably put people off transferring, which may be generally positive, but suggested that presenting somebody with a ‘huge number’ representing the value of staying in the scheme was not the way to help clients understand their choice.
‘It seems the only way you can actually position that with the client is to say this number doesn’t really exist, this is a number that is hypothetical, let’s put that to one side and look at the Apta – so then I’d question the purpose of it if the only reason it’s there is to be discounted.’
Percival agreed discounting at this lower rate artificially increased the TVC figure.
He said: ‘I’ve been doing some events with Prudential over the past three months, and the example they are using is the CETV is £423,000, and on the consultation basis the loss from the full value is £126,000, but the loss under the policy statement version, the actual version that we have now, is £353,000.
‘The right-hand column is £776,000, and that is common with a lot other TVCs I’ve seen: they seem to be in the 30-50% loss being shown. That is a big shock for the client, because they see this £423,000 CETV but then they are told that it is costing them £353,000 to transfer. The advisers are saying that basis is not fair, and I agree with that view.’
This problem, he explained, may mean advisers would dismiss the TVC when sitting down with clients, thereby diminishing the impact the regulator hoped it would have.
Keep calm and carry on
Andy Boyt, compliance director at Cardiff-based Juno Moneta Capital Management, said IFAs would have to make do with the rules in their current form.
‘We have a different perspective in that we perceive there will be consistent growth in invested assets for the next five to 20 years, and they don’t see it that way from the perspective of your DB pensions,’ he said.
‘(The FCA) says you are taking virtually no investment risk as a DB member, so we need to reflect that in the information you receive. In the real world where we as IFAs operate, certainly you are taking on investment risk, so you need to understand the difference between the two.
‘That’s where we come in, but we have to start from the same point and say: “This is your statutory starting point as set out in the regulations; however, we are going on a journey so I can explain to you as an individual what this means, personalised to your circumstances through my Apta process, my advice process, my cashflow forecasting process.”’
One thing the FCA could do is take the TVC out of the advice process but require it for triage work.
‘Because it is impersonal, because it’s statutory, I don’t think it can be interpreted as a personal recommendation,’ said Boyt.
‘What if we take them out of the equation before that through the triage process? They’ve got to enter a certain amount of information about themselves in order to get a TVC but it should be in front of them on a pension statement that they’ve got from the trustees.’
EQ Investors’ senior technical consultant Dan Atkinson (pictured above) said the TVC could form communications from scheme trustees, describing it as the ‘awkward child’ next to the Apta.
‘There are points where you get the “big number, little number problem”. When the member is getting their CETV they are not given the context of the TVC that uses sensible assumptions. That should help them understand whether this is a really bad idea or whether it is worth exploring before they have to consider all the parts of the advice process.’
The devil is in the detail
Percival said: ‘I think the FCA has made a mistake – not necessarily in the way the calculation works. It’s not inherently wrong, although I think the consultation paper version is fairer. But I think the impact will be negative to what they are trying to achieve. Advisers will be more dismissive of the TVC because of the calculation basis. If the calculation basis were as of the consultation paper, I don’t think advisers could argue with it and be dismissive with the client.’
In the meantime, he suggested, advisers needed to give due prominence to the TVC, while explaining that it is a complicated representation of the value of the scheme and not an exact science.