Consulting Actuaries

A ban on DB scheme transfers?

Royal London Consulting Actuaries

28 May 2014

The 2014 Budget was widely portrayed in the media as introducing flexibility for money purchase arrangements, but also included some potentially significant restrictions for defined benefit (DB) schemes, as described in section 5 of the paper "Freedom and choice in pensions".

In particular it raises the prospect of a ban on transfers out from DB schemes. It is also unclear how Additional Voluntary Contributions (AVCs) should be treated.

The proposals are subject to a public consultation, which closes on Wednesday 11 June 2014.  Our views on the DB consultation, together with background explanations, are as follows. 

Should the government continue to allow private sector defined benefit to defined contribution transfers and if so, in which circumstances?

In our view transfers should continue to be allowed in accordance with the current legislative rules without the imposition of further restrictions.

Changes to pension scheme legislation should be considered carefully to avoid unintended consequences.

It can be logical and beneficial for a member of a DB scheme to transfer his/her entitlement to a defined contribution (DC) arrangement in the following circumstances.

When in poor health

A member in poor health at retiral may wish to transfer his DB benefits to a DC arrangement in order that his spouse will receive a greater retirement income if he dies earlier than his spouse. (Not all DB schemes provide a spouse's pensions on death in retirement)

If unmarried

An unmarried member may wish to transfer his DB benefits to a DC arrangement in order be able to pass on his pension savings, including the value of the spouse's pension he does not require, to his dependents.

During the divorce process

As part of a divorce process the ex-spouse may wish to transfer the benefits within the DB scheme awarded by the court to her own DC arrangement.

If emigrating

A member may wish to emigrate to another country where only DC arrangements are available.

For early retirement

A member in poor health, or who has been made redundant in later life, may wish to take early retirement but is unable to do so within the DB scheme. In such circumstances the right to take a transfer value to a DC arrangement may be the only option to enable the individual to support himself.

To avoid future benefit restriction by the PPF

On leaving employment a member with a significant entitlement within a DB arrangement may wish to transfer his accrued entitlements out of the DB arrangement to avoid the adverse effect of the PPF compensation cap if at some future date the employer becomes insolvent.

As part of a de-risking strategy

UK employers may wish to offer de-risking options to members including the option of a transfer value in order to implement an appropriate de-risking strategy.

For the majority of DB scheme members the security provided by the DB scheme will outweigh the perceived flexibility offered by the proposed DC regime. However as described above for some members the flexibility offered by a transfer to a DC arrangement may outweigh the perceived security.  Quite rightly the Government has stated that "each individual's circumstances are unique" and so just as for DC savers, DB pension savers should be trusted to make their own decisions about what is best for them.

The options for private sector DB schemes

The options outlined for private sector DB schemes are as follows. Click on each to read our opinions and comments.

Remove the right of all members of DB schemes to transfer to a DC scheme, except in exceptional circumstances.

This proposal is not practical, it would be an unfair and unnecessary restriction on members' rights and options.

It may also be contrary to article 6, paragraph 1 of the proposed EU Directive on improving the portability of supplementary pension rights, which states that:

  • Unless a capital payment is made in accordance with Article 5(2), the Member States shall take the necessary action to ensure that if an outgoing worker is not covered by the same supplementary pension scheme in his new job, he may obtain on request and within 18 months after the termination of his employment the transfer within the same Member State or to another Member State of all his acquired pension rights.

Allow transfers from DB to DC arrangements but ring-fence the transferred amount and subject it to the old DC tax framework.

Extra costs so this proposal is not practical

This would impose significant extra administrative complexity on DC providers which would imply additional costs to be met by the individual.  It would create two classes of DC account.  It would almost certainly cause confusion to individuals at retirement.

Placing a cap on the amount which can be transferred from DB to DC in any year.

Not practical. This would add significant extra administrative complexity on to the DB scheme administrator which would increase costs for UK businesses.

Members may be confused as to why only part of their benefits has been transferred and may fail to understand why they are required to request a series of transfer values over a number of years. Members may also consider that the Government has prevented them from obtaining good investment returns on their pension savings by delaying the full transfer.

It could lead to an additional "stranded pots" problem if a transfer value exceeded the cap by say £5.

Continuing to allow DB to DC transfers but only subject to Trustee approval

Significant legal risk for Trustees so not practical.

Trustees are not authorised to give financial advice to scheme members, but this proposal would impose an obligation on them to allow, or disallow, a transfer to a DC arrangement. To the member this would be seen as implied advice that the transfer was a good idea, hence the scope for a lawyer seeking "mis-selling" redress from Trustees if a DC transfer does not turn out to be beneficial in the long term would be large.

Leaving in place the existing flexibility and arrangements for transfers from DB schemes to DC arrangements

As described above, there are good, sensible, member-centred reasons why the existing legislation permitting transfers from DB schemes to DC arrangements should continue. Consequently we favour this solution, which has the additional benefit of not adding any additional costs on to scheme administrators or HMRC.

Hybrid schemes

If your scheme provides both DB and DC benefits, eg an AVC, then the government is looking for help on how to deal with the new tax regime.  

In our view, pension schemes have developed "hybrid" features over time as a consequence of changes to legislation. In our opinion, rather than consider a hybrid scheme as a single entity for the purpose of the proposed tax regimes, it is more sensible to consider each benefit structure as it accrued at the time and to apply the relevant tax regime to that part of the benefit accrual. This is consistent with the approach taken by the PPF which requires money purchase elements of accrual to be separated from the DB compensation, treated as separately identifiable DC pots and to be provided by a separate DC provider, when a scheme enters the PPF.

The most common form of hybrid scheme is in fact a normal DB scheme with AVCs.

AVCs operate predominantly as DC pots. They accumulate due to the member choosing to pay some of his savings into an investment vehicle run by the DB scheme.  It is likely that members will have understood the Budget and subsequent Government statements to mean that they will be able to exercise all the new flexibilities of the DC regime for their AVCs, particularly if they have other DC arrangements in respect of other employments.  In our opinion the DB part and the AVC part of the scheme should be treated separately with the DB part subject to the DB legislation and the AVC part subject to the DC legislation. This is consistent with the approach taken by the PPF.

Hybrid schemes which provide DB entitlements for one period of service and then DC accumulation thereafter.

If the scheme does not provide a "better of" comparison  between the benefits then these are very similar to the DB with AVC model above. Again, in our opinion the DB part and the DC part should be treated separately with the DB part subject to the DB legislation and the DC part subject to the DC legislation.

Where a hybrid scheme offers a "better of" comparison, the member cannot know the form of the benefit until retiral and it could change each day. The Government must decide which tax regime should apply.

Any system which only decides the relevant tax legislation at that time will cause uncertainty for the member and could lead to mistakes due to misinterpretation of the tax regime.  The Budget announcement has already decided that Cash Balance schemes, which have previously always been considered to be a form of DB scheme, will be subject to the proposed DC tax regime. In view of this we suggest that the Government should decide to treat all   "better of" comparison hybrid benefits as subject to the proposed DC tax regime, thereby removing possible confusion for individual members.

How should the government assess the risks associated with allowing members of private sector defined benefit schemes to transfer to defined contribution under the proposed tax system?

Given the existing safeguards, the government does not need to be any more concerned about DB to DC transfers than it is about DC savers making use of the proposed DC flexibilities.

The current regulations require that before an individual transfers DB entitlements to a DC arrangement he must obtain specialist professional advice to understand the nature of the benefits involved and the risks inherent in such a transfer. The existing system is designed to ensure that members understand the balance between security within the DB scheme and the possible flexibilities offered by the DC regime. In our opinion members are able to weigh up this balance for their own specific circumstances.

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