Frequently Asked Questions
A Defined Benefit pension is much more secure than the pension income provided by a Defined Contribution personal pension where risks are borne by the individual rather than the scheme.
Though the benefits are a liability of the scheme sponsor (the employer), they are not guaranteed. But they are protected at three different levels:
- The employers as scheme sponsor, providing contributions to fund accrued benefits and to meet any future shortfall in accumulated contributions
- A scheme-specific trust fund that receives and invests the contributions; is ring-fenced from the sponsor’s balance sheet; is governed by regulations general to trustees and actuaries and specific to pension trustees
- A mutual fund, The Pension Protection Fund, funded by contributions from all schemes to provide a safety net if a sponsor fails to meet its liabilities. These three forms of security are explained here.
The risk of a Defined Benefit scheme is limited by this protection as to both the chance of a shortfall and the size of the possible shortfall.
The chance of a shortfall
The chance is a joint function (ie reflecting how both interact) of i) the strength of the employer relative to testing business or economic conditions and ii) the adequacy of the fund’s assets to meet all liabilities. But if the fund looks like it may not be able to meet its liabilities in full, such as because bad economic conditions have reduced the value of the fund’s investments relative to an objective valuation of its liabilities, the fund has to look to the sponsor for more money. If the same conditions are testing the sponsor, it may not be able to do much to improve the funding position quickly.
Though specific to the firm, the chance of the liabilities not being met by the sponsor is subject to change over the potentially long period before benefits are paid. Strong firms can become weak firms through bad management or events beyond their control like new technologies. The longer the period before the pension starts being paid, the less reliance can be placed on an assessment of the current strength of the employer.
The strength of the fund, in terms of holding sufficient investments at every stage to meet a actuarial assessment of the amount needed to meet all liabilities, is also subject to change with investment market conditions. This change can be limited, however, if the fund holds more (or only) low-risk assets whose expected return is always the same as or close to the return required to meet the liabilities. Such assets are known as risk free or hedging assets, because changes in the value of the liabilities will be matched by a change in the value of the assets. Most funds have increased significantly the level of hedging assets relative to property and equity investments whose market prices do not move closely with the interest rates used to measure the liabilities.
They have also increased their contributions. Over the past decade, roughly half the contributions paid by private-sector Defined Benefit schemes are to make good technical shortfalls. Additional contributions are as large as the regular cost of accruing benefits for employees. This reflects the unreversed reduction in interest rates after the banking crisis rather than the effects of the crisis on equities and property, which did reverse.
The size of the possible shortfall
The size of the risk is a function of the rules of the Pension Protection Fund. These determine how much the full pension benefits due can be reduced in the event of the scheme entering the fund. The impact is predictable as long as you can see how the rules would apply in your own position.
Though predictable, it is not prudent to assume that the rules that apply today will not change in the future. As long as the mutual fund does not enjoy a Government guarantee and depends on sponsors for its capital, it may itself become stressed in periods in which sponsors generally are stressed. It cannot therefore make calls on sponsors collectively when it needs to. In that situation, it is possible that rule changes will dilute the protection currently provided.
The most important of the current rules are as follows.
If you retired early and had not reached your scheme’s normal pension age when the scheme entered the PPF, then you will generally receive 90 per cent level of compensation based on what your pension was worth at the time. The annual compensation you will receive is capped at a certain level.
The cap at age 65 is, from 1 April 2017, £38,505.61 (this equates to £34,655.05 when the 90 per cent level is applied) per year. From 6 April 2017, the Long Service Cap came into effect for members who have 21 or more years' service in their scheme. For these members the cap is increased by three per cent for each full year of pensionable service above 20 years, up to a maximum of double the standard cap. The earlier you retired, the lower the annual cap is set, to compensate for the longer time you will be receiving payments.
If you were beyond the scheme’s normal retirement age when the scheme entered the PPF, the PPF will generally pay 100 per cent level of compensation.
For both sets of compensation above, in respect of active members: payments relating to pensionable service from 5 April 1997 will rise in line with inflation each year, subject to a maximum of 2.5 per cent a year. Payments relating to service before that date will not increase. This is potentially less inflation protection than the failed scheme was expected to provide.
In respect of deferred members pre-retirement: compensation will increase annually in line with inflation between the time your former employer failed and the date your compensation comes into payment. This annual increase will be subject to a cap of 5% for compensation linked to pensionable service prior to 6 April 2009, and a cap of 2.5% in respect of compensation linked to pensionable service on or after 6 April 2009. The first is likely to be comparable with the original terms but the second may be weaker inflation protection.
This is generally in line with the terms of the failed scheme.
Assessing the risk
This can be done by any member but clearly benefits from professional expertise and judgement. Since advice is required for any transfer over £30,000 (see here) it makes sense to look to the adviser to assess the chance and size of any shortfall in the promised benefits.
The content of the adviser’s report that is prescribed by the FCA includes the level of the reduced projected pension, assuming the scheme did enter the PPF and that there was enough of a shortfall in scheme assets to require the full reduction. It does not require any assessment of the chance of that event.
It also requires a calculation of the return that the invested CETV amount would need to achieve, up to retirement, assuming that, at retirement, the capital was used to but an annuity with the same inflation protection (known as the ‘critical yield’), so providing the same ‘real’ income as the Defined Benefit pension. This may be academic if the intention is to draw down rather than replicate the form and level of the promised benefits. (Prior the instigation of the PPF, it was more likely that a member of a Defined Benefit scheme would want to transfer out to avoid the more serious consequences of the failure of the sponsor to pay benefits in full, even if they intended to use the money to buy an annuity.)
The prescribed calculations do not include the possible erosion of the real value of the Defined Benefit pension once it is being paid by the PPF even though this may be more significant than the cut in the initial pension amount. In a good transfer report this should form part of the comparison of possible real income as between remaining and transferring.
In all cases, the assessment of the risk should form part of the reasoning about the merit of transferring but in most cases it will not dominate the calculation of relative advantage.
You should be aware that unscrupulous advisers and pension scammers are likely to play up the risk to encourage a transfer they anyway want you to undertake.
You should accept a CETV if that amount of money can provide more personal benefit than the pension income itself.
This highlights the two different aspects of good advice and a good decision:
- Accurately identifying how you personally value all the different forms of benefit each can provide
- Making good projections of the possible outcomes by comparison with the known outcome of the Defined Benefit pension income
The two dimensions of the problem are not independent of each other. Good projections of the possible outcomes contain information that you can use to define what provides most benefit, what best describes ‘a job well done’ or minimises regret. Only you can define this but it may need help.
Since any transfer in excess of £30,000 requires a qualified specialist adviser, you are likely to want to derive value from that exercise in terms of both dimensions. The skill set required to qualify as a pension transfer specialist is based on knowledge and application of a set of rules. The skill set required to identify what benefits individuals seek from their resources and how they make value judgement is general to financial planners rather than specific to pension specialists. The skill set to quantify probabilities for the outcomes of a transfer into a drawdown plan combines actuarial and investment knowledge and should have more in common with the work performed in the Defined Benefit world than in retail investment services. After all, the Nobel-Prize winning American economist Bill Sharpe described drawdown as the most complex problem he has ever encountered in finance!
The quantification aspect of the problem is not limited to comparisons of gross income, even if this is in most cases the most important factor for the decision. A transfer also changes the number and nature of options when you have control and flexibility. Some of these options can be readily quantified, such as the likely income for a surviving spouse (because it can be costed from a life assurance quotation) and comparisons of tax free cash. But potential taxation effects are harder to assign a value to.
Here is a list of the aspects of a transfer than may or may not apply to you.
- You value the chance of higher lifetime spending
- You want to 'profile' your spending at different ages
- You value the chance of passing unspent capital to heirs
- You would value getting out more tax free cash
- You don't want your spouse's pension income to be cut
- You want to avoid cuts to income caused by failure of sponsor
- You want to access your pension earlier than the scheme allows
- You may need to manage taxable income to avoid higher rate tax
- You are in poor health
The first of these, a comparison of outcomes, is addressed in a simplified version of the Fowler Drew drawdown model you can experiment with here. This is limited to gross income and assumes a level real draw to age 95. Differences in outputs about the level of draw can nonetheless be used to think about what you personally might value and why, such as taking more risk, even if you don’t need that much additional spending, because your heirs will value a bequest.
This strikes at the heart of the improvement in CETVs as a multiple of pension income. CETV calculations are not arbitrary: regulations prescribe how trustees should calculate them, as a best estimate of the amount of money needed at the effective date of the calculation which, if invested by the scheme, would be just sufficient to provide the benefits. It has to take into account the assets held by the scheme. If the scheme has ‘derisked’, from holding equities to holding fixed income assets, that will tend to increase the cost of providing the benefits and therefore the CETV. If they still held as much in equities as they used to, expected returns on the fund would be higher and so the cost of providing the promised benefits would be higher and the CETV multiple would be correspondingly lower.
The higher multiples are only worth more to the member than the Defined Benefit pension if the member would choose to hold more in equities than the scheme chooses. The member would choose to hold more in equities if that meant that the real income the capital could eventually buy was higher than the real income if the capital was instead invested in the same way as the scheme. Though the member might value these higher expected outcomes, how they value them is probably also subject to some constraints, such as not falling short of the income they were due to get from the Defined Benefit pension by more than a certain (possibly quite small) amount. They are visualising the consequences of different outcomes when these are necessarily uncertain.
The difference in investment preferences between the scheme and the member can be explained in economic terms by something called ‘utility’ or ‘welfare’. You can think of this as what matters most, or what best describes success and minimises regret. It can be captured in preferences such as between securing minimum benefits and increasing benefits; between short-term progress and long-term outcomes.
It is also often about consequences. CETVs were much lower when there was little difference between how schemes and individuals thought about their own utility. Collective individual views about utility have not noticeably changed. But new accounting rules and regulatory changes have definitely altered the way private Defined Benefit pension schemes think about their utility, against their natural inclinations, because they introduced a new set of consequences. Stability in the funding adequacy and hence of contributions now dominates factors such as maximising long-term outcomes or minimising the long-term costs of pension provision. It is the difference in the typical scheme and the typical individual’s utility that makes the resulting CETV worth more to many members than the cost of providing the benefits.
If an individual’s own utility is defined in ways that result in the same sort of choices and trade offs that the sponsor has already made, such as because they want to avoid ever having to adjust their spending down, even if they give up any chance of improving it, then even these higher CETVs are likely to be no more attractive to them.
You cannot know: you can only make an assumption or an estimate. It is too important for it to be guesswork alone which is why all transfers with a CETV of £30,000 or more require advice from a qualified specialist (below that the cost of the advice might make it counter-productive).
Because a transfer involves the member taking on risks otherwise borne by the employer or sponsor of the Defined Benefit scheme, the outcomes are either known (in real terms), in the case of the Defined Benefit pension, or some range of possible real outcomes, in the case of the Defined Contribution pension. Where a range is involved, it is prudent to focus on quantifying the range and its associated chances, rather than estimating the most likely outcome. It is prudent because it is skeptical about people’s ability to pick a particular outcome from a range and because individuals can then think about the different consequences of better or worse outcomes to guide them to a choice between the two options that most closely matches the features they value.
In economic terms this is described as maximising utility, ie what matters most, or what best describes success and minimises regret. Since utility can be hard to express in abstraction, thinking about the consequences of the range of outcomes (the levels of income at different confidence levels equivalent after tax to real spending) will help you exhibit your utility directly. This is the reverse of the conventional approach to risk preferences in which they are expressed first in abstract and that then leads to a product or solution an adviser thinks matches the expressed risk preferences.
The adviser’s transfer report is required to make some comparison between the Defined Benefit income (projected in today’s money) and the possible benefits if you transfer. But the form of the comparison is not prescribed and there is no requirement to quantify the full distribution of possible outcomes or assign any chance to whatever point forecast or assumption is used.
In most adviser transfer resports the comparison is limited to two outputs:
- The required investment return that would match the level of income assuming either an annuity is purchased or a managed drawdown is preferred
- Assuming a particular return, how long the capital would last if the same real income as the Defined Benefit pension was drawn.
The report is unlikely to include the information the individual most wants which is i) the appropriate level of actual draw that meets constraints they themselves set and ii) the potential for increasing that draw or for creating additional wealth.
The limited toolkit of the adviser community contrasts with the much more sophisticated toolkits that pension scheme actuaries use to advise their clients. These rely on modelling (or simulating) the full range of possibilities so that both an eventuality and its likelihood can be used to inform decisions.
Actuarial models are themselves not perfect. They tend to rely on normalised assumptions about investment risk and return. The possible outcomes of a drawdown portfolio should not be static or normalised. The portfolio should be managed dynamically so that the levels of risk vary both with age and the recomputed funding position (the risk level changes even if the risk approach, like utility, remains constant); and the expected returns vary with changes in the achieved returns up to every point (the funding position changes less than market levels change). A probabilistic drawdown model needs to allow for the impact on the sustainability of the draw of the sequence of market conditions during the draw.
A probabilistic model of a drawdown portfolio should have mathematical solutions for all of the following.
- The return dynamics in the presence of a draw, capturing both financial-market risk and uncertainty about inflation
- Constraints in terms of minimum tolerable draw
- Constraints in terms of the tolerances of temporary cuts in draw
- Constraints in terms of how long the capital has to last with or without cuts in draw
- A direct link between risk aversion and the outputs above
A simplified version of the Fowler Drew drawdown model, which has solutions for all five, can be accessed here. This will allow you to quantify for a given CETV the sustainable real draw on the basis of a fixed constraint of age 95, no tolerance of cuts to draw and five risk aversion alternatives. On these arbitrary, simplified inputs, the calculator will give you the confidence of achieving the same or higher income than the Defined Benefit income and the very low-probability best- and worst-case income.
The investment of the CETV amount should not be planned in isolation but should be part of a holistic plan for meeting your retirement objectives and other goals. Ideally, the expected Defined Benefit income is already a risk-free part of the expected retirement spending and so for any unchanged attitude to risk the replacement of that risk free asset should logically alter your current risk approach.
You might assume this will depend on whether the capital is assigned to replacing the Defined Benefit income or to some other goal such as bequest at death in a tax-efficient manner. However, as long as your existing plan for retirement income assumes the underpinning of the Defined Benefit income, it will need to be replaced by some other source of income if not the CETV.
As explained here, because a risk free asset is being replaced by a risky asset, any unchanged risk attitude should logically lead to a change in the overall risk level compared with the capital pre-transfer. This highlights the importance of planning holistically. You should not treat the CETV as either an independent increment or as a resource equivalent to existing resources. It is likely, however, that new goal planning triggered by exploring a transfer option will lead to changes in your existing approaches to risk.
Though it is limited to the CETV amount, you can use a simplified version of the Fowler Drew drawdown model here to see how your own inputs lead to outputs for the drawdown portfolio including the starting asset allocation and the associated short-term volatility. The inputs are the CETV amount, the time horizons for the draw and a selected risk aversion level. The outputs include the high-level asset allocation for the starting portfolio and the maximum expected 12-month loss (on paper) at 95% confidence. Both are aspects of the portfolio you need to be sure you could live with, even if it is long-term outcomes for spending and surplus wealth generation that dominate your decision making.
The asset allocation is limited to the split between risk free assets and risky assets because this split is what mainly governs the range of sustainable draw for each time horizon. (It is a far more reliable means of risk control than relying on diversification. It mimics the way Defined Benefit actuaries and trustees have had to think about the best ways to manage risk and chose to focus on the separation between risk free ‘hedges’ and return-seeking ‘bets’.) It is the sum of the allocations to each in every horizon, which has its own resource level assigned and its own asset allocation. Nearby years of spending are funded entirely by risk free assets and the furthest years entirely by a geographically-diversified mix of equity markets. Intervening years are a mix. The risk level will determine both the current mix and the speed with which the portfolio derisks as the consumption horizon draws nearer. These dynamic effects are captured in the range of sustainable draw for the plan as a whole in the diagram.
The Cash Equivalent Transfer Value (CETV) obtained from transferring rights from a Defined Benefit pension scheme can only be paid into a registered personal pension plan. How you take benefits from it is then governed by whatever legislation applies at the time.
With the introduction of the new ‘pension freedoms’ legislation in 2014, all previous restrictions on the amount that can be withdrawn from a Defined Contribution pension have been lifted, except that access is still prevented until age 55. This is good news since it allows people to better tailor their pension withdrawals to suit their personal circumstances and tax situation and prevents people from sleepwalking into the purchase of a poor-value annuity product.
However, the wider range of pension withdrawal options (Flexi Access Drawdown, Uncrystallised Funds Pension Lump Sum, Flexible Annuity), and the associated tax consequences of each, make the retirement landscape far more demanding. With professional guidance, the optimal choice from amongst these alternatives may in fact be clear, following naturally from the degree of freedom to vary income sought by the member or from the member’s tax position.
In most cases the fundamental challenge is independent of the particular arrangement chosen: how to maximise retirement spending without running out of money before death.
It is still possible after the pension freedoms to buy an annuity to turn the pension capital into an income stream. The annuity will deal with the risk of running out of money before death as well as the risk of investment returns falling short of required returns. An annuity can also be chosen that matches closely the inflation protection provided by the scheme pension. But since these are all features of the Defined Benefit plan you started with, to achieve a higher real income requires the CETV when invested during the period up to the point you wish to take benefits to earn a significantly higher return, after expenses (which are likely to be higher without the economies of scale of the Defined Benefit scheme), than was assumed by the scheme when calculating the CETV it should offer.
That required return should have a very high chance of being exceeded to justify a transfer on the basis of size of income alone, to compensate for giving up the security of the income provided by the Defined Benefit scheme. The required return merely to equal the scheme income is a calculation (known as the ‘critical yield’) required by the rules governing advising on a transfer. It will rarely justify a transfer and most advisers would advise against transferring where the member’s intention was to replicate the level of security of the Defined Benefit scheme by buying an inflation-indexed annuity with equivalent spouse benefit.
An exception to that general rule is where the security of the ceding scheme was itself in question, for instance, if the promised income was well above the maximum level that would be paid by the Protection Fund if the scheme had to be rescued by the PPF and there was a significant period before retirement when the employer’s solvency was at risk. The size and personal consequences of the potential cut might then be far more important than any assessment of the chance of that happening.
Exceptionally, there may also be particular individual circumstances that are important enough to dominate the decision. But these will be harder to find support for from an adviser, unless exceptionally compelling, and may in any event be covered by the scheme’s freedom to offer, at a price, alternatives to the contractual pension.
You have no recourse to third parties if, with the benefit of hindsight, you have made errors of judgement about risk and uncertainties inherent in the transfer that you understood and accepted at the time. That contact with reality is a reminder of how risk is transferred from a scheme to a member when opting for a transfer.
You may have recourse, however, if you were misled on matters of fact by a third party or given poor advice, provided that the advice was not itself an error of judgement that any informed person might have made.
If the Cash Equivalent Transfer Value was over £30,000 and therefore you were required to take advice, you will have a documented advice process you can examine for possible misinformation or for errors of judgement that were not consistent with the standard required of a professional. These could be grounds for complaint. You may take any unresolved complaint to the Financial Ombudsman Service (FOS). As a general principle, the advice given is tested in terms of what should have been expected could happen, rather than what actually did happen;, and the likely impacts are considered in light of your personal situation at the time of the advice, even though the actual consequences on which damages are assessed will reflect what actually happened. FOS’s assessment of the compensation due is generally calculated to put the individual back into the position they would have been in without the advice. Since it is not possible to return to the Defined Benefit scheme, an equivalent financial award is necessary. The Ombudsman’s decision is final and binding.
Advisers are required to carry Professional Indemnity insurance and so any award is likely to be met in practice by the insurance industry rather than the adviser’s own financial resources. In the event your adviser is no longer trading and a successor firm has not inherited its liabilities, a successful award of compensation by the Ombudsman would be met by the Financial Services Compensation Scheme (FSCS).
If the reason for your complaint was that you were subject to a scam, it is more likely that you will receive an award but also that it is unlikely to be recoverable other than from the FSCS.
In the event the amount of damages exceeds the maximum FOS can award, an individual has recourse to the courts but whereas FOS is free legal action may prove very expensive and requires any damages and costs to have a reasonable chance of being recoverable.
These protection mechanisms are not subject to any time limit.
Find out if transferring your pension is right for you
Speak to one of our advisers on 0207 736 2434.
"Deciding whether you should or should not move a final salary scheme is frankly terrifying. I recently went through this process with Fowler Drew and it went very smoothly. The team were calm, highly experienced and very helpful ensuring that all scenarios were explained, tight deadlines were met and communication was continual and supportive. I’m confident that Fowler Drew’s process is robust and will ensure the correct outcome in your situation."Mr G Financial Services
"Fowler Drew provided me with an exceptionally rigorous and thorough comparative analysis of the benefits of accepting a cash equivalent transfer value payment from my defined benefit pension to be invested in my SIPP. Having reviewed the analysis, I decided to proceed . Arranging the transfer payment and re-investing it proved to be very straightforward."Mr F London
"As always David and your team were excellent and helped me come to the right decision, which was to draw the pension immediately with a lump sum early rather than transfer. It was a very thorough process, and enabled me to look at all of the options carefully before coming to an informed decision."Mr H London