Transfer Incentives

It has become an increasing trend recently for employers with final salary and career average schemes to offer active and deferred members incentives to transfer out to alternative pension arrangements.  Members need to ensure they are fully aware of the risks of accepting an incentive because transferring may not always be in their best interests.

It should be noted that some employers are also targeting existing pensioner members.  They are offering incentives to give up non-statutory post-retirement increases in return for one-off cash payments.

Background

Final salary and career average schemes are becoming increasingly expensive to operate.  This is due, in part, to increased member longevity and disappointing investment returns.  As a result, to ensure funding obligations are maintained, employer contribution rates are increasing, sometimes to unmanageable levels.

To reduce their liabilities, and therefore their costs, employers may decide to take serious remedial action.  They may decide to wind up their final salary or career average schemes, thereby transferring all pension liabilities to money purchase arrangements.  They may alternatively choose to close the schemes to new entrants and/or stop accrual for existing members.

Usually, transfer values do not represent fair value for the benefit given up.  Often, the transfer value is reduced to reflect the scheme's funding deficit.  The pension ultimately produced by the transfer value will not be as much as the deferred pension from the scheme. 

New Development

It is generally considered to be more cost-effective for an employer that a scheme member transfers out to another scheme than to retain that member's deferred pension liability.  For that reason, it is in employers' interests for their deferred members to transfer out.

Transferring from a final salary or career average scheme to a money purchase scheme or personal pension plan is not generally considered to be good value for money.  So, to encourage deferred members to transfer out, some employers are offering financial incentives.

The Incentive

The incentive offered can be in the form of a direct cash payment, an enhanced transfer value, or both.

This practice is not illegal and does not contravene any regulatory rules or guidelines.  Companies have business and commercial reasons for needing to reduce liabilities and this is one legitimate way of doing it.

However, members must think seriously before accepting an incentive offer.

They should seriously consider taking independent financial advice before accepting an incentive offer to ensure it is in their best interests.

They should also be cautious if advice is made available by the employer as the adviser involved may not be acting in the members' best interests.  There have been reports that employers are paying for each scheme member to be advised but paying double for each member that agrees to take a transfer.

The Impact on Members

Transferring from a final salary or career average scheme to a money purchase scheme (or personal pension plan) carries a number of risks.  The following are the issues that a member should consider before agreeing to an employer's incentive to transfer.

• Final salary, career average and money purchase schemes could not be more different.
  
  Final salary and career average schemes provide benefits based on a fixed formula, with reference to a member's completed service and earnings.  For example: Pension = (Service/60) x final salary.
  
  The money purchase scheme provides benefits based on the investment growth of the contributions paid into the scheme and the rates available at retirement to convert the pot into an annuity.
  
  It is therefore fair to expect that the benefits available at retirement will be vastly different.

• The trustees are responsible for managing any funding risks associated with final salary and career average schemes.  The trustees must ensure their schemes are sufficiently well funded to meet their liabilities.  Members are just required to pay their own contributions.
  
  With money purchase schemes, members are responsible for managing the risk.  If they want a specific level of retirement income, they have to manage the contribution levels (above any contractual obligations) and monitor and react to the investment performance.  This may involve paying higher employee contributions that are required by a final salary or career average scheme and regularly switching investments to curb potential losses.

• The cost of buying an annuity has steadily increased over recent years.  In the last two years, the cost has increased by 5%.  That means a member's money purchase fund will buy 5% less pension.  The cost of combating these changes fall on the member in a money purchase scheme but on the employer in a final salary or career average scheme.

• Many final salary and career average scheme members have, in recent years, lost some or all of their retirement income as a result of their employers becoming insolvent or simply winding up their schemes.  This has been reported widely in the media and has been a consideration for many members voluntarily transferring out to safer, yet generally inferior, money purchase schemes.
  
  The last few years have seen changes to pension law.  Now, final salary and career average scheme members are protected from the problems that affected other members in the past.

• If an employer is solvent but voluntarily winds up the scheme, they have have statutory funding obligations.  They must fully fund the purchase of the members' benefits.  If there is a funding deficit, as is likely, they are obliged to pay into the scheme whatever is required to fully fund the transfer of liabilities.
  
  Despite this legal duty, a very small number of employers have avoided their full funding obligation by compromising their debt.  This usually happens where an employer cannot afford to meet the debt in full or, by paying the full amount, the company's solvency is compromised.  With The Pensions Regulator's approval, the employer and trustees can reach a compromise, effectively reducing some all of the members' entitlements.

• If the employer is insolvent, the Pension Protection Fund (PPF) is likely to step in.  If there are insufficient assets to fully meet the scheme's liabilities, the PPF may take over the administration of the scheme and pay out benefits as and when members become entitled.  The PPF pays:
  • 100% of expected benefits for those already over the scheme's retirement age and those in receipt of ill health pensions.
  • 90% to all other members, including pensioners who retired early but have not yet reached the scheme's retirement age.
  • Pensions capped at £28,742.67 per annum at age 65.
  • Revaluation in deferment at the lower of RPI and 5% per annum.
  • Pension increases in retirement of the lower of RPI and 2.5% per annum on benefits accrued after 6 April 1997.
  • No pension increases in retirement on benefits accrued prior to 6 April 1997.
  • Spouse's pension of 50%.
  • Early retirement and transfers are not allowed.
• If a cash incentive is offered, the member may be liable for any tax and should therefore discuss the payment with their tax office.  If the member is a higher rate taxpayer, this could have a huge impact on the value of the incentive.  Members should therefore use the net value of the incentive when considering the transfer offer.

Members should seriously consider taking independent financial advice before accepting a cash incentive to transfer to ensure that it is in their best interests.

For further information about transfer incentives, you may want to refer to guidance issued by the Pensions Regulator.  Click here to see the guidance.