Discussion Paper for JFAR December 2019
The role of actuaries in DB to DC transfers
1.1 Trustees are required, by law, to quote cash equivalent transfer values (CETVs) and, before they can calculate them, must have taken advice from their actuary as to the appropriate assumptions to use. Actuaries are closely involved in this process but do not make the ultimate decision on the transfer value basis to use. The eventual decision is one for the trustees.
1.2 There is some professional uncertainty as to what member options should be included in the transfer value calculation (eg tax free cash).
1.3 Actuaries will also advise the trustees on whether and by how much to cut back CETVs to allow for scheme underfunding. However, there are very few instances of CETVs actually being reduced for underfunding.
1.4 Transfer values are set on a “best estimate” basis. This results in a lower value being paid out than is being reserved for on the scheme’s funding basis (which will contain margins for prudence). The difference to the full “buyout” cost associated with securing benefits with an insurer is even greater.
1.5 Therefore, scheme funding tends to improve when members transfer out. This creates an incentive for employers, trustees and those who advise them to encourage transfers. Actuaries will also often advise corporate bodies on the costs of their DB pension schemes. Part of this process includes de-risking strategies which involve removing DB liabilities from the balance sheet (individually through member options, or in bulk through buy-outs and hedging strategies) and in devising communication strategies for schemes’ membership.
1.6 The member’s decision on whether to transfer will be made after receiving financial advice (if the CETV is greater than £30,000). Actuaries may be involved directly in the advice process and, indirectly, in specifying some of the calculation routines and disclosures shown to clients during the process. Those who advise on DB transfers are regulated by the FCA and operate separately from the scheme actuary.
1.7 Actuaries may be involved in the mechanics of the calculation of CETVs. This could be a direct role in the calculation or, more usually, an indirect role, where calculations are carried out on the basis of instructions issued by the actuary.
1.8 The scope for harm arising from an unsuitable decision to transfer a DB pension is significant. The FCA estimates that average FOS redress of around 16% of CETV is typical, with current CETV averages of around £350,000 (ie over £50k per case). They estimate that total redress of £1.6bn-£2bn each year could be due (based on current volumes of transfers). Even if the market has peaked and demand for transfers reduces in future, the sums could be still be substantial.
1.9 With a low interest rate environment transfer values are at historical highs (as is the cost of replacing such benefits in the insurance market). However, whether these high transfer values will be able to produce sufficient retirement income depends on many factors and requires communications that help the transferee to appreciate the assumptions that are being made and what they mean for the future in terms of the underlying risks to the members.
2 De-risking exercises and scheme communications
2.1 Many actuaries are employed by benefit consultancies, who advise companies and trustees. Encouraging members to transfer their benefits out of a DB scheme improves funding levels and reduces the cost of a potential buy-in/out. However, giving up DB benefits is unlikely to be in the interests of most members (the view taken by the FCA, TPR and government). This generally holds true for many members, even after the introduction of the pension freedoms. Therefore, the output of actuarial advice could be viewed by some as an encouragement to poor consumer outcomes.
2.2 There is some evidence that schemes that both promote transfers as a retirement option and provide transfer values more routinely have higher proportions of members seeking advice. Some benefit consultancies actively promote to employers the proactive communication of transfer values to members. This may also result in more members seeking advice to transfer – the key risk being the quality of communication they have received.
2.3 Actuaries working with scheme sponsors to design de-risking exercises or communication exercises often produce member material which does not present a balanced view of the merits of transferring (compared with the risks). For instance, an at-retirement presentation of an often significant CETV against a much lower annual income are likely to sway the member towards the higher sum - most members are not versed in making value considerations and therefore inclined to put more weight on the ‘bird in hand’ argument. Further, evidence suggests that members often place too high a value on the perceived flexibility of the pension freedoms which can push them towards a transfer.
2.4 Actuaries may also be involved in selecting a suitable adviser if the trustee or employer wishes to offer members a preferred firm (and potentially pay for or subsidise advice). This requires carrying out appropriate due diligence to ensure that the firm selected has robust processes in place to provide suitable advice.
2.5 On incentive exercises (enhanced transfer values or pension increase exchanges) actuaries are often involved in selecting the group of members to make the offer to and selecting the timing (based on favourability of market conditions and ‘gaming’ of the IFA industry metrics). Actuaries need to be clear about how the exercise effects the various stakeholder groups. This may be covered by the industry Code of Practice
3 Impact of new TPR funding regime
3.1 The new funding regime, due to be consulted on in early 2020, may result in more cautious funding bases and investment strategies and a corresponding potential; to increase CETVs.
3.2 This may make CETVs more attractive to members as evidence has shown that demand for transfers rises as average CETVs increase. Schemes and employers may also be more motivated to encourage transfers to reduce funding liabilities, and to reduce the cost of insured solutions, potentially without a clear explanation to members of the value of benefits being given up.
3.3 Some schemes are including CETV decrements in their funding assumptions and thus taking advance credit for expected CETV savings.
4 Impact of recent political and legal developments
4.1 The recent court ruling requiring equalisation of GMPs will have the effect of increasing benefits for some members and hence their CETVs
4.2 Replacement (or gradual dis-use) of the RPI index in favour of a CPI index will have the effect of reducing benefits in those schemes where pension increases are still linked to RPI, and a consequential reduction in CETVs.
5 Transfer values and actuarial factors
Reducing transfer values
- 5.1 Actuaries are involved in providing advice to trustees on whether to reduce CETVs to reflect scheme under-funding, and on how much a reduction should be. This is an option that has historically been little used.
- 5.2 Going forward, and particularly under the proposed new funding regime (where funding levels may fall), there may be greater pressure to reduce CETVs to protect the security of benefits for non-transferring members.
- 5.3 Actuaries will therefore increasingly need to balance the needs of all members in recommending reductions to the trustees. There could therefore be a conflict between professional judgement and commercial pressures arising from their employers and their clients.
- 5.4 DB schemes are permitted to transfer out only part of members’ benefits but, to date, few schemes (perhaps 1 in 6) have offered this option even though there is an increasing focus on the flexibility of such an option.
- 5.5 Actuaries (and the firms who employ them) may play a central role in recommending whether to offer partial CETVs and to advise on a basis of calculation.
- 5.6 The IFoA has launched its Actuarial Monitoring Scheme (AMS) with the announcement of a thematic review (in 2020) into actuarial factors used to calculate pension scheme benefits. The review will look at current practices adopted by actuaries in this area including how factors such as commutation at retirement are determined for schemes and how frequently these factors are reviewed.
5.7 Commutation factors, where these are not fixed in scheme rules, are often set at a level which is favourable to the scheme, which effectively makes a “profit” when members take cash.
5.8 Commutation factors are particularly relevant to the assessment of DB to DC transfers as they effectively represent giving up 25% of a member’s DB benefits (most members take their full entitlement). The risks here are similar to full DB transfers, albeit at a lower level.
5.9 Financial advice is needed for transfers of over £30,000. Many tax-free cash payments are above this level, but no financial advice is needed to give up this guaranteed, lifetime income. Giving up pension on unfavourable terms may not be in members’ best interests and may not reflect their actual needs in retirement.
5.10 Actuaries are often involved in designing member communications and this has often remained silent on the merits, or otherwise, of taking a cash sum instead of pension.
Other DB scheme advice
5.11 Actuaries may also be involved in assessing the basis (albeit uncommon these days) for DB transfers-in. There is a need to ensure consistency with transfers out.
5.12 CETVs are used in pensions sharing on divorce. Actuaries need to take care that they are not favouring/ disadvantaging one or other of the parties involved. Some actuaries specialise in advising divorcing couples on their pension options.
6 Actuarial Roles
Role of actuaries involved pension superfunds transactions
6.1 Superfunds are designed to consolidate DB schemes and could be a cheaper alternative to an insured buyout. Although the funding regime for superfunds has yet to be finalised, CETVs payable may be at a higher level than for DB schemes given the potentially more conservative investment strategy.
6.2 Actuaries will also be expected to play a key role in assessing risks to see if a superfund is the best option for a scheme (as opposed to insured buyout or running on in its current form).
6.3 Given commercial pressures to reduce liabilities and increase returns to investors, there may be an incentive to encourage members to transfer which could be greater than in the original DB schemes. Actuaries working for superfunds may therefore find themselves conflicted.
6.4 When preparing for entry to a superfund there may also be pressures to reduce the liabilities before they have transferred across. Employee Benefit Consultancies and the actuaries who work for them may be part of this process.
Role of actuaries at buyout providers
6.5 Policies that have been fully bought out will generally offer surrender values to non-retired policyholders (the insured equivalent of CETVs). Actuaries working for providers will be involved in setting the surrender basis.
6.6 As with superfunds, there could be competing priorities and pressures arising in terms of the needs of the provider and the transferring policyholders. There will also be pressures arising on trustees to reduce liabilities before buyout takes place.
Role of actuaries at advice firms and providers
6.7 Actuaries may work at providers who can benefit significantly from the inflow of income from DB transfers. They may be involved in the production of promotional material and evidence has shown that there is often a lack of balance in terms of the merits of a DB transfer (eg downplaying the safety net provided by the PPF on employer insolvency – the value of the PPF may be further strengthened pending the outcome of the Bauer case).
6.8 Some actuaries are also employed by advice firms, where similar issues arise. The work here may also involve designing projection models which can show an over-optimistic assessment of the returns to be gained from a personal arrangement.
7.1 As this paper has highlighted, there are a number of public interest risks which could affect the actuarial profession arising from members’ work on DB transfers.
7.2 Challenges could be made regarding not clearly communicating the risks of transfers to members. Actuaries could also be seen as failing to fully balance the needs of all members when advising on aspects of DB transfers as they are affected by conflicts between their professional judgement and commercial pressures arising from their employers and their clients. These may be areas for the Pension Working Group to look into further.
7.3 Effective communication is at the heart of the value that the Actuary can bring to society and actuaries are often involved in designing communication material to DB scheme members. Commercial pressures may mean that communication material may often over-play the merits of a transfer or under-play the benefits of guaranteed lifetime income.
7.4 With scheme funding issues likely to increase over time, the pressures on actuaries advising in this area are also likely to become more significant in future.
7.5 There are also overlaps between the issues in this paper and those called out in the 2019 Risk Perspective being developed separately.