Once in a lifetime opportunity? Maybe for some.

Pension transfers and investment matters

Pension planning has two clear stages: saving up and drawing down. Advisers, and possibly clients, will have many years' experience of the saving up phase – but very little of the drawing down stage, especially over extended periods.

Not so many years ago, a DB pension was deemed to be "guaranteed" but as we have seen with BHS/Tata and a myriad of smaller schemes which fail, often un-noticed, this concept is no longer absolute.

The need to access a sustainable inflation linked withdrawal rate while maintaining an appropriate level of capital is key. Rather than simply trying to maximise returns, investors are trying to maximise "durability" of income.

This durability is one of the fundamental risks associated with taking a DB transfer.

Pensions freedoms and home equity

Recent changes in pensions legislation and the very high CETVs (Cash Equivalent Transfer Values) mean that for many people, their pension will become their largest asset – possibly of much higher value than even their home. It is therefore natural when faced with this large and important asset that people will want to preserve it. Unfortunately for many this will mean not taking any risk (risk of loss), and invest in cash. When in fact one of the most pernicious long-term risks is inflation – and cash is a poor asset to protect against inflation.

It may be a better outcome for an investor with a full state pension entitlement, to spend their pension pot faster than a typical annuity / DB pension would allow while they are in good health. Knowing that they have significant home equity in their main residence to draw from in later life. So long as they understand the impacts and risks of this strategy the improved "quality of life" that they can enjoy for say 10 years with a higher income, could be a compelling reason for a DB transfer to access more flexible benefits.

The rapid rise in equity release products, and the improvement in the product over recent years, may also be a factor to consider in wider pension (long term income) provision.

With sensible planning, it is now possible to pass pension wealth to future generations very tax effectively. This is assisted by the new Residence Nil Rate Band for IHT.

The interaction between the pension and IHT tax regimes, the need for long-term income, the potential need for long-term care, the need for a diversified asset mix of real assets inside your pension fund (not just owning a residential property outside your pension fund), the tax-effectiveness of investing inside a pension wrapper, the triple lock (or double lock) on state pension benefits, the enhanced death benefits and IHT planning available under pension freedoms all serve to highlight the critical need for professional impartial advice when considering a full or partial transfer of DB scheme benefits.

What is clear is that a simple critical yield assessment is flawed.

The state of DB schemes

One important factor to consider when planning to transfer from a DB scheme is the health of the scheme and the risk of it failing to meet some, or all, of its future liability.

This takes on greater significance for those with higher benefits that are yet to retire (as the Pension Protection Fund (PPF) only covers pensions to a cap). The cap at age 65 is, from 1 April 2017 this equates to £34,655.05 (when the 90 per cent level is applied), set by DWP.

Note: The PPF has approximately £3.5bn of assets and receives c £540m a year in levies. Level of UK DB scheme deficits is c£300bn. So, there is more than a little gap if there is series of large calls.

Not so many years ago, a DB pension was deemed to be "guaranteed" but as we have seen with BHS/Tata and a myriad of smaller schemes which fail, often un-noticed, this concept is no longer absolute.

One important factor to consider when planning to transfer from a DB scheme is the health of the scheme and the risk of it failing to meet some, or all, of its future liability.

State of the pension nation

Hymans Robertson research shows that:

  • DB liabilities are now greater than UK GDP
  • For many schemes benefits being paid out are greater than contributions being paid in.
  • An estimated £10bn a year will flow out of DB schemes

Previous requirements for schemes to match their liabilities to bonds means that schemes have been holding the "wrong" long term assets (bonds) to meet long-term inflation linked liabilities. Indeed, any rise in inflation could lead to a rapid fall in bond prices further exacerbating the funding gap for DB schemes.

High CETVs

The very low bond yields have driven CETVs from DB schemes to very high levels. Some investors have seen the CETVs more than double in a very short period, and critical yields even being driven negative – CETVs more than 100 times the pension are not uncommon. It is exactly these long and sustained falls in bond yields that has driven transfer values from DB schemes up. As the discount rate has fallen, the cash required today to buy out a given liability has risen.

Many commentators are concerned about the significant risk in bond markets that ultra-low yields have created – while there is currently no sign of a liquidity crunch, the prospect of rising inflation may trigger a rapid reversal of yields and sharp fall in bond prices. And as we have seen in credit markets historically this can be a rapid and violent change in direction.

Note: CETVs are driven by the discount rate (usually long dated bond yields adjusted for the scheme asset allocation mix), inflation rates and the scheme demographics. Rising inflation expectations as well as falling long dated bond yields will typically increase transfer values.

From a long-term return perspective, it is easy to see why a transfer value, based on bond yields of less than 1%, invested in a broad equity portfolio, with a 3-4% dividend yield could make a move from DB to DC worthy of consideration at least from an investment perspective.

Particularly when you consider the steady rate at which dividends have been maintained by FTSE ALL Share companies see Figure 1.

Figure 1. FTSE All-Share Index Dividend Yields (blue) and Annual Total Returns (red). Source: Siblis Research

Chart

In the weeds

Without seeking specialist advice, many clients will think there is a binary choice between DB "guarantees" or DC "non-guaranteed". This does not have to be true: A strategy of utilising a short term (guaranteed) annuity to bridge the income gap to state pension age, or secure guarantee of nil rate income tax band for non-earners could be appropriate. Indeed, a single person with grown up children may be able to secure a guaranteed income equal to their DB scheme benefits and still have remaining cash. I would expect to see a rising demand for, and development in, the annuity market (long term guarantees up to 30 years) which offer valuable long-term certainty.

Armed with a professional financial adviser (coach), a low-cost well-diversified portfolio and a sensible approach to investment and income provision, the opportunity presented by all-time high CETVs make a transfer a once-in-a-lifetime opportunity.

With thanks to Janice Russell, Specialist Pension Adviser at Russell Retirement Solutions, for her valuable input. This is an abridged version of a longer article – please contact Dan (David) directly if you wish to see the original.

To review this article in full please request via email: david.norman@tcfinvestment.com