The Financial Conduct Authority in the UK revealed plans for changes mid 2017 with regard to Defined Benefit pension transfer advice
They have scrapped historic guidance that the adviser should start from the assumption that a transfer will be unsuitable.
This is long awaited and a welcome relief for expats whom are not considered at all by the current FCA rhetoric.
For the 10 – 20,000 expats that transfer their pensions each year this change should bring a more holistic and balanced approach to the required FCA regulated advice reports.
The core principal is that the FCA have moved away from the automatic headline that pensions should not be moved, to a more client focused approach.
Expats’ needs are not taken into consideration as the FCA concerns itself with UK residents only.
The changes also include requiring transfer advice to be provided as a personal recommendation, and replacing the current transfer value analysis with a comparison to show the value of the benefits being given up – these changes are still filtering through in 2018.
The FCA consultation report stated:
“It remains our view that keeping safeguarded benefits will be in the best interests of most consumers. However, the introduction of the pension freedoms has altered the options available and for some consumers a transfer may now be suitable when it wasn’t previously.
“We therefore propose to remove the existing guidance that an adviser should start from the assumption that a transfer will be unsuitable. This will be replaced with a statement in the Handbook that for most people retaining safeguarded benefits will likely be in their best interests and guidance that advisers should have regard to this.
“This will not require an assumption to be made by an adviser. An assessment of suitability should focus on whether a transaction is right for the individual and should be assessed on a case by case basis from a neutral starting position.
“The adviser needs to demonstrate that the transfer is in the best interests of the client.”
The proposals include:
– replacing the current transfer value analysis requirement (TVA) with a comparison showing the value of the benefits being given up
– introducing a rule to require all advice in this area to be provided as a personal recommendation, which fully reflects the client’s circumstances and provides a recommended course of action
– updating FCA guidance on assessing suitability when giving a personal recommendation to convert or transfer safeguarded benefits, so that advisers focus on whether a transaction is right for a particular individual
– introducing guidance on the role of a pension transfer specialist
Taken together as a package, the proposals will “ensure that advice fully takes account of an individual’s circumstances so that consumers make the right decision for them”, the FCA stated.
Christopher Woolard, executive director of strategy and competition at the FCA said: “Defined benefit pensions, and other safeguarded benefits such as guarantees, are valuable so most consumers will be best advised to keep them.
“However, we recognise that the environment has changed significantly, so we want to ensure that financial advice considers the customer’s circumstances in full and recognises the various options now available to them.
“Our new approach should better equip advisers to give the right advice so that consumers make well informed decisions.”
The FCA stated: “Our new approach builds on the rules and guidance which are currently already in place for advice of this nature including our recent pension transfer alert.
“The clarity provided by this consultation should better equip advisers to give the right advice. This will help consumers make well informed decisions which consider all relevant factors to allow them decide whether or not to transfer. It will also give consumers confidence in the advice that is being provided, whether or not this results in a positive recommendation to transfer.”
These changes go some way towards supporting the individual, whether they are an expat or not, make the right decision for them.
Moving to an international SIPP allows the expat several advantages both now and in the future.
To understand more click here
Contained in the reports are two benchmarks namely Hurdle Rate and Critical Yield
Critical Yield is the estimated investment return, after charges, that must be achieved in order to receive retirement benefits at least as good as those offered by a Defined Benefit Pension Scheme. This is normally achieved through the use of a Transfer Value Analysis System, or TVAS.
TVAS is an automated system which calculates the investment return required from a Personal Pension fund to provide the same benefits as those given up by transferring. The system is dependent on demographic and economic assumptions which are stipulated by the FCA in their handbook detailed in COBS.
This is where the assistance of a deVere Pension Transfer Specialist comes in. It is their job to help our clients analyse the CETV, taking into consideration personal needs and financial circumstances.
Once that’s done and carefully documented we can then help clients consider the costs of moving, the potential benefits gained or lost by moving and the required Critical Yield which will determine whether moving from a Defined Benefit Pension Scheme represents good value or not.
Critical Yield Assumptions.
There are various assumptions that have to be taken into consideration for us to be able to calculate the Critical Yield of any given transfer.
Revaluation rates to be applied to the benefits through to the member retirement date
Indexation/escalation rates for the benefits once they come into payment
For example, an increase in the annuity interest rate would mean that the amount of capital needed to provide the same annuity would decrease and the Critical Yield would decrease. If mortality improves then the Critical Yield would increase.
A key point is that meeting the Critical Yield does not guarantee matching benefits. For benefits to match, all assumptions need to be met identically.
The Critical Yield could be exceeded and benefits not matched if the other assumptions are not met. Conversely, the yield may not be achieved but benefits matched due to a compensating change in other assumptions.
The assumptions are by their nature subjective and likely to change as they include matters such as expected inflation and changes in average earnings.
Critical Yield – an example.
To highlight what a Critical Yield is in simplified terms, here’s an example.
– David has a Defined Benefit Pension Scheme (Final Salary Pension) with Ford Motor Co.
– He has had a letter telling him he will receive an annual income of £6,500 per year starting on his 65th birthday which is in 10 years’ time.
– His pension will continue on his death for the balance of 5 years from commencement and then 50% to his spouse.
– The income will rise each year in line with RPI.
This is all very well but David would like to find out whether it would be to his advantage transferring the ‘cash equivalent transfer value’ to a Personal Pension.
– David requests a CETV which confirms a value of £280,000.
– Using simple figures, we assume the scheme pension rises by 2.5% per annum over the next 10 years and therefore would rise to £8320.
– If the CETV is transferred to a Personal Pension and a 3% (£8,400) fee is applied, then the value of the Personal Pension would be £271,600.
– If the value of fund then grows by 7% per year over the next 10 years but charges reduce this by 1.5% per annum to 5.5% then in 10 years’ time the Personal Pension would be valued at £463,931.
– If annuity rates for a 65-year-old male, with a 50% spouse’s pension provide an annuity rate of 2.8% then the Personal Pension valued at £463,931 would provide an income of £12,990. i.e. £463,931 x 2.8%.
This is well above the guaranteed income being provided by the current Defined Benefit Pension Scheme.
Where Critical Yield comes in is calculating the rate of growth required to match David’s projected Defined Benefit Pension Scheme income of £8320 per annum.
For this to be advantageous, the Personal Pension value must equal (£8320 ÷ 2.8%) = £297,142 in 10 years time. Therefore, the Personal Pension plan would need to grow at 6.1% after charges, 7.6% before charges giving a Critical Yield of .76% per annum.
Critical Yield and Annuity rates
Annuity rates are historically low at the moment due to a number of factors including people living longer and gilt yields being driven down by low interest rates and quantitative easing.
A rise in annuity rates of 2% in David’s example would make a huge difference.
– £8320 ÷ 4.8% = £173,333. Making the actuarial calculation somewhat mute because the comparison is with the currently forecast higher amount due to the gilt market conditions.
It can be seen that the forecast pot would be much less and taking the transfer value and investing it would easily outstrip the potential future annuity cost.
The basic calculation to work out a Critical Yield uses a ‘standard’ annuity rate. Many people could benefit from enhancements to the annuity rate they receive due to their health or lifestyle factors which may reduce their life expectancy compared to the ‘standard’ person.
When you combine this with the potential for annuity rates to rise in the future from their historic lows you can quickly see how the calculation can be deemed as flawed.
It is important to note that not everyone will receive an enhancement and the fall in annuity rates could be here to stay and not be a short term trend.
Critical Yield/Calculations/Assumptions – What about the individual?
What the Critical Yield calculations cannot possibly take into account is the individual and their wider financial circumstances, objectives, health, income needs, lump sum needs, taxation position, financial dependents, financial knowledge, experience and attitude to investment risk.
When we used to consider a ‘Pension Transfer’ from a Defined Benefit Pension Scheme to a Personal Pension clients were ultimately forced to use part of their CETV in certain ways and did not have full flexibility.
– They would have to buy an annuity once they reached age 75.
– They would have to provide death benefits to a spouse in the form of an annuity with the ‘protected rights’ section on death.
– The value of any residual fund on death would have highly penal tax charges applied if drawn as a lump sum by loved ones.
With the introduction of Flexi-Access Drawdown (FAD) and its removal of the need to consider maximum Government Actuary’s Department (GAD) limits, the opportunity to take large, irregular and ad-hoc income payments creates further complexity in ensuring the sustainability of a client’s pension income.
These changes all have an impact on Critical Yields when assessing clients’ circumstances.
So, are Critical Yields still relevant?
A Critical Yield still provides a good yardstick when trying to understand if a CETV provides good or bad value. In addition, where an individual wants the security of a guaranteed future income, again the Critical Yield shows the level of growth required to match this.
However, if a member wants an income similar to that provided by a Defined Benefit Pension Scheme, transferring out of a Defined Benefit Pension Scheme to a Personal Pension (incurring charges and investment risk in the interim) it may or may not be in the clients’ best interests.
When considering whether, or how, to use Critical Yields it is worth exploring other ways of identifying a drawdown income’s sustainability. Examples of alternatives might include using a cash flow modelling tool or by identifying and commenting on the number of years before the pension fund is likely to be exhausted.
Overall, for any pension scheme, income stability is key. For clients to achieve this, whether through a Personal Pension or Defined Benefit Pension Scheme, requires professional analysis including a Critical Yield calculation.