Pension funding options

In this section, we explain the rights and options of employees who leave service prior to retirement with accumulated pension rights

If employees leave their employer’s occupational pension scheme prior ...

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...6 April 2006, as an alternative to providing a refund of employee contributions, employers have to offer a transfer value to members who have completed more than three months but less than two years qualifying service.

Revaluation rates

Until legislation was introduced by the Social Security Act 1985 revaluation of preserved pension benefits was not available. This Act however, in order to counter the effects of inflation on preserved pension benefits, introduced the revaluation of preserved pensions over and above any GMP within defined benefit schemes earned for service from 1 January 1985. However, this only applied to leavers in 1986 or after.

The following table summarises the revaluation position for preserved defined benefit pensions:

EFFECTIVE DATE (Date of leaving scheme)

GMP

EXCESS OVER GMP

6 April 1978

One of:

S21 Orders

Fixed Rate (8.5%)

Limited Rate

None

1 January 1986

As above

RPI, maximum 5% on pension accrued from 1 January 1985

6 April 1988

Fi...

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...ts changed from 6 April 1997. From that date early leavers pensions had to be split into two:

Firstly, GMP which stopped being accrued after 5 April 1997 is separately identified and subject to the rules of revaluation described above

Secondly, all benefits accrued after 5 April 1997 are known as “requisite benefits” and no longer get split between contracted out and non contracted out portions. Requisite benefits have to be revalued in accordance with the RPI or CPI from 6 April 2011 to a maximum of 5% (2.50% from April 2009) per annum averaged over the period from leaving to taking retirement benefits.

Defined contribution schemes

The member’s accrued benefit must continue to vary in accordance with the value of its underlying investments, after deduction of charges.

In this section, we describe the fundamental basis on which pension transfer values are calculated

Defined contribution schemes

Where a scheme operates on a defined contribution basis, then the transfer value of a member’s rights will closely resemble the value of that person’s share of the scheme whether it be an individually earmarked arrangement or, a portion of the scheme’s overall fund value. This figure could be affected by charges and/or penalties depending upon when funds are released.

Basics of calculation of transfer value for defined benefit schemes

To explain the basics of how to calculate a member’s transfer value from a defined benefit scheme, we shall work through an example of the four step process:

Step1 Calculate the member’s pension preserved at the date of leaving

This will be based upon length of service, pensionable salary and the scheme’s accrual rate. In addition the member may have purchased extra service via AVCs or transferred benefits in from previous employments.

In our example, Bob accumulates on leaving service, a pension of 20/60ths x £33,000 = £11,000 per annum, where pensionable service is 20 years and final pensionable salary is £33,000.

Step 2 Revalue pension benefits from date of leaving up to the scheme’s normal retirement age

As a minimum this should be in accordance with statutory revaluation which is the lesser of RPI (CPI from April 2011 onwards) or 5% (2.5% for post 5 April 2009 accrual).

With Bob’s pension the benefits accrued prior to 6 April 2009 and he has 15 years left to normal retirement age, so benefits will be revalued at...

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...o; costs, although it does state that the costs estimate may be based on past experience. However, the trustees must also offset any ongoing administrative savings that will result if the member transfers out of the scheme. Any such reductions should be shown on the “statement of entitlement” provided to the member. This is a written statement of the amount of cash equivalent at the guarantee date of any benefits which have accrued to or in respect of the member under the scheme rules;

Allowance for scheme under-funding - where the scheme is under-funded, the trustees may offer CETVs which are less than the transfer value calculated on the best estimate basis. However, this may only be done after obtaining an insufficiency report from the scheme actuary. The amended 1996 Regulations permit the trustees to use their discretion to decide whether it is appropriate to use the last relevant GN11 report as an insufficiency report if its assumptions differ from those used in calculating members’ ICEs. However, TPR’s guidance states that trustees should not generally reduce CETVs, even if the scheme is under-funded, if the employer’s covenant is strong and any recovery period is not too long.

The transfer club

This scheme only really applies to a small band of pension schemes primarily operating in the public sector. In the transfer club a standard actuarial basis is applied to incoming and outgoing transfers when taking place between club members.

The result is that member’s benefits will be very similar to what they would have achieved had they always been in employment with the second employer based on actual past service.

 

In this section, we describe the use, application and interpretation of transfer value analysis systems (TVAS).

Objective of the TVAS

The object of the TVAS is to calculate the “critical yield” (using various assumptions) required from an individual pension plan to match the benefits provided by the transferring defined benefit occupational pension scheme at retirement.

The critical yield can be expressed simply as follows:

Transfer value less charges x (1+ i)n = capitalised value of scheme benefits. Where “i” is the critical yield and “n” is the term from date of transfer to retirement.

Assumptions used

Any critical yield calculation will involve assumptions in terms of:

Annuity interest rate

Revaluation rate

Indexation/escalation rate

Mortality.

These assumptions are set by the Financial Services Authority (FSA). They are primarily based around the annuity interest rate.

Annuity interest rate

The annuity interest rate reflects the yield to redemption on high coupon medium and long-term gilts. The FSA specifies this rate and currently sets it annually for each tax year. Currently it is set at 4.1%.

Revaluation rates

Two main revaluation assumptions are required:

RPI, currently at 2.5%

Average earnings index (AEI) currently set at 4.0%.

Statutory revaluation - For the purposes of calculating the critical yield, actual inflation is used to the date of transfer with an assumption of 2.5% thereafter.

Revaluation in accordance with s.148 orders - The current FSA assumption for the TVAS ca...

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... preferences – not selected merely to achieve the critical yield.

Ill-health, death and retirement benefits

In addition to considering final pension benefits at retirement, the following factors are important in determining whether a client should transfer benefits away from their defined benefit scheme:

Ill health

If the client is in poor health the levels of ill health benefits available from the ceding scheme need to be compared with the receiving arrangement.

Health, medical and other benefits

It is important to check what additional benefits would be available during preservation and lost on transfer such as health and medical arrangements.

Death benefits

Death benefits could come in a number of ways such as an income or lump sum payment to a spouse/civil partner or dependant.

If the scheme is contracted out, the minimum death benefits is a GMP for widows/civil partners, plus Reference Scheme test pension benefits for post April 1997 service. Benefits above this will be subject to scheme rules.

A lump sum death benefit may be payable although this is restricted usually for leavers to a return of member’s contributions with or without interest.

Early and late retirement benefits

Comparisons should be conducted between the benefits available at ages at which the member is considering retiring. Early retirement benefits can be reduced considerably and if the ceding scheme has good early retirement terms with low or no penalties applicable it would be hard to match those benefits with any new receiving arrangement.

 

In this section, we discuss the link between attitude to risk and asset allocation within the receiving scheme’s investment fund in order to attempt to achieve the critical yield.

Factors to consider including ethical considerations

There are several factors that are likely to affect a client’s attitude to risk and these need to be discussed in order to ensure that there is a level of understanding between what they find acceptable and what assets need to be selected to achieve the desired critical yield. Some important factors are highlighted below:

Timescale to retirement

A period of more than 10 years t...

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...n that asset allocation contributes to a large percentage of the variability of returns. Even so, individual stock picking and tactical asset allocation at different times can enhance overall returns considerably.

Major asset classes considered are: cash, fixed interest securities, property and equities with other asset classes such as derivatives being utilised also. This text will not go into any great detail on the different asset classes, but it is important that the adviser is appropriately aware of their behaviour both in terms of returns and interaction between each other when constructing a suitable portfolio with the client.

In this section we consider the implications of transferring benefits from the UK to overseas pension schemes.

Introduction

Those leaving a UK pension scheme to work overseas permanently have the usual options as to what to do with their accumulated pension benefits including leaving them in the UK pension scheme or transferring to a UK individual pension plan. They can also:

Transfer benefits to an occupational scheme in the other country; or

Transfer benefits to an individual pension arrangement in the other country.

The rules for pension transfers from UK registered pension schemes to overseas pension schemes are more straightforward than the old rules in place before 6 April 2006. However, it might be argued that they are less flexible than before.

Before moving on to look at the new rules in more detail, it is worth noting the following:

As with pension transfers within the UK there are different rules, and tax implications, depending on whether a pension transfer overseas is a recognised transfer or a non-recognised transfer

The only recognised transfers to overseas schemes are transfers from UK registered pension schemes to qualifying recognised overseas pension schemes (QROPS). Any other overseas transfer will be a non-recognised transfer – with the related tax implications

In some circumstances, pension transfers can be made by in-specie transfer of assets from one pension scheme to the other – rather than paying a cash transfer value

Contracted-out rights ...

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... in a 12 month period, is more than 25% of the individual’s fund value the individual will have a further unauthorised payments tax surcharge of 15% of the transfer value.

To cap it all, if more than 25% of the scheme funds are paid as non-recognised transfers the scheme could be de-registered. This would mean a further de-registration tax charge for the scheme of 40% of its total assets.

Annual allowance

Non-recognised transfers, in themselves, don’t have any affect on an individual’s AA.

However, where non-recognised transfers of money purchase rights are involved, the usual AA rules apply and any payments made in the pension input period up to the time of transfer will still count against the individual’s AA as usual.

Conversely, where non-recognised transfers from defined benefit (or cash balance) schemes are involved, none of the transferred benefits will count against the individual’s AA for the pension input period up to the time of transfer.

Lifetime allowance

Non-recognised transfers are not BCEs, so they have no impact on an individual’s LTA. The transferred benefits will never be tested against the individual’s LTA – not at the point of transfer, or when the benefits come into payment, or when the individual crystallises benefits under other UK registered pension schemes.

Reporting to HMRC

Any non-recognised transfer from a UK recognised pension scheme must always be reported to HMRC by the UK scheme administrator.

In this section we consider the implications of transferring benefits to the UK from overseas pension schemes.

Introduction

The following options are available to an individual transferring accumulated benefits from overseas to UK:

Leave benefits in the overseas pension arrangement

Transfer benefits to a registered UK occupational scheme

Transfer benefits to a registered UK individual arrangement.

The new rules for pension transfers to UK registered pension schemes from overseas pension schemes are more straightforward than the old rules in place before 6 April 2006. Pension tr...

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...ion agreement (DTA) containing exchange of information and non-discrimination provisions (see Helpsheet IR304 on the HMRC website www.hmrc.gov.uk for high-level details of the UK’s DTAs),

or

• Any other country or territory if all of the following conditions are satisfied:

1. At least 70% of the funds must be used to provide a pension income on retirement at, or after, normal minimum pension age, and

2. Retirement benefits cannot be paid earlier than would be allowed under a UK registered pension scheme, and

3. Residents of the country (or territory) can join the scheme.

In this section we consider the compliance issues surrounding pension transfers based on understanding of the FSA’s model guidance notes originally published by their predecessor, SIB in 1994.

Introduction

When making a recommendation to transfer preserved pension benefits from an occupational pension scheme, an adviser should carry out a detailed comparison between the ceding scheme and the new arrangement as well as obtaining comprehensive information on the client’s personal circumstances and objectives.

In order to ensure that the necessary stages of the advisory process can be completed, the adviser should initially gather sufficient information, using a fact find designed specifically for pension transfers. The information required will include:

Details of the client’s personal and financial circumstances

The client’s understanding of risks involved with the transfer as well as their attitude to investment risk

The client’s aims and objectives including future career aspirations and desired retirement age

Comprehensive details of the ceding scheme

Whether the client’s new employer provides arrangements that will accept transfer payments.

Once sufficient information has been gathered, a transfer value analysis can be undertaken to assess the critical yield required to match the available benefits under the ceding scheme.

It will be the adviser’s duty to assess the analysis before drawing conclusions and recommendations to the client. The adviser should ensure prior to making a recommendation, that the cli...

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...eceiving plan.

Pension transfer checklist

The FSA does not specify whether a checklist should be used when advising on each pension transfer but it is commonly regarded as good practice to do so. The checklist should incorporate sections asking questions as to whether the following areas are fully understood by the client:

Preserved benefit options including refund of contributions, and immediate retirement

Benefits held within the existing pension scheme and full understanding of the rights that may be given up

The transfer value analysis comparing benefits provided within the ceding scheme and those that may be offered by the receiving arrangement

Risk relating to investment risk in terms of the new plan as well as the risks associated with either giving up benefits in the ceding scheme or retaining them in there. In addition, the client needs to understand annuity risk in terms of the implications this may have on final pension benefits

Full details of any new employers scheme particularly one that can accept transfers in on an added years basis and whether this may be a better option for the client given the inherent guarantees and index linking to salary that it will provide.

Other reasons for transfer and the arguments for and against these reasons

Proceeding with the transfer and understanding why a certain type of plan and product provider has been chosen

The type of advice being offered e.g. tied, multi tied, independent and how that advice is remunerated

Charges of the receiving arrangement and the effects these can have on reducing yields.