There’s nothing a politician loves more than to surprise the electorate with ‘good news’. We’ve become accustomed to so much bad financial press over the last few years that anything appearing to be good news tends to lift the spirits of grass-roots supporters and suppresses criticism from the opposition.
Pension changes in 2015
The new pension freedoms recently announced by George Osborne are good news for retirees. They allow much greater flexibility on how to receive income and pass on wealth to the next generation. Death taxes are scrapped (although deferred might be a better description), benefits can be accessed earlier, and retirement income can be higher. The pension industry was just as surprised as the general public at these developments, as they had not been consulted. It took a while for the news to ‘sink in’. Having paused for thought, the industry has returned with commentary on the new rules and some of their unintended consequences.
Firstly, it should be noted that the new rules only apply to defined contribution (DC) schemes. Final salary or defined benefit (DB) schemes are largely unchanged. It would seem that the reason for this is to protect people from unscrupulous financial salespeople who might repeat the transfer scandal of the late-80s, where public service workers were wrongly advised to transfer out of their DB government-backed pensions into DC schemes. However, an unfortunate consequence of this development may be that DB scheme members are now at a disadvantage.
Public service workers were specifically screened out of the new freedoms; if everything goes through as announced, they will not be allowed to take advantage of legislation changes. Whilst this is probably in the best interests of most, it can’t be ideal for everyone. There are always exceptions; one has to ask whether the government is covering its own back here, as a run on transfers would be paid from Treasury reserves. What about someone who is retiring to France, for example? Who will pay compensation if it turns out that the retiree is worse off by not transferring to a European scheme? All it would take is a strengthening of the Euro, and the UK scheme would become lower in value without anything else happening.
Handle with care
In general, an adviser would tread very carefully when discussing a potential transfer out of a final salary pension plan with a client. The pension industry uses calculations based on what is known as ‘critical yield reports’ to present the difference between staying put and transferring out of a DB scheme. This critical yield is the percentage annual increase in the value of a fund to equal, surpass or underperform someone’s DB scheme. For example, the calculation may show that a DB scheme member would need to achieve 5% growth per annum to equal, and anything above to exceed, benefits offered by their scheme. A good adviser would, of course, also assess the impact of any additional benefits that may be forfeited by ‘transferring out’, such as life assurance or disability insurance. Keeping it simple though, the main driver is value. Will I be better or worse off by doing this transfer?
There is no all-encompassing answer to this question. To make the decision even harder, the answer could change from one year to the next. In a good year, the market value will increase by more than expected, whereas in bad years, it will reduce. This means the critical yield will change from one year to the next. Similarly, a DB scheme might appear attractive before and on retirement. Still, it might suddenly become completely useless if its underlying investments aren’t managed well, or the company has financial problems and isn’t able to maintain contribution levels.
At present, there is a window of opportunity for UK public sector workers who have a good argument for transferring out of their employer pension scheme. They are allowed to transfer to either a self-invested personal pension or a QROPS, providing they do it before the beginning of the next financial year in April 2015. If you are considering this route, you must talk to a suitably qualified adviser. In the future, it is also possible that the government may take a closer look at the legislation and allow transfers after April to be made if someone is permanently emigrating. As of yet, this unintended consequence doesn’t seem to have been taken into consideration by the powers that be.
This issue will inevitably crop up at some point in the future; the pension industry will do its best to help the government iron out the wrinkles in the legislation. One suspects that a lengthy consultation period would not have fitted well with the upcoming UK election. No government has ever announced good news just after an election. That period is reserved for pushing through all the ‘tough decisions’ in terms of policy. It would appear that good news should be announced, even if it hasn’t been properly thought out, well in advance!
Phil Loughton – AXIS Strategy Consultants