What QE means for transferring your pension
A deliberate exercise by central banks to distort the normal workings of capital markets, Quantitative Easing (QE) has provided an exceptional opportunity to improve financial outcomes by transferring from final-salary pension schemes to self-invested personal pensions schemes (SIPPS). Transfer is from risk being borne by others to bearing the risk yourself; from a pension based on what you earned as salary and for how long, to one based on what your capital earns in the markets. Though intuitively unappealing, this risk transfer is likely to increase both i) levels of after-tax wealth (be it capital or income) and ii) aspects of flexibility and control that many retired people value.
The chance of worst value always exists but, because of QE, we have never seen it as low. So much so that in simulated conditions in which significant loss arises we ought logically to assume the entire framework of guaranteed or insured pension income would itself be under stress. Public markets provide no free lunches but Government intervention in public markets can have that effect. This comes close.
There is no guarantee that the terms of transfer will not improve further, keeping the transfer window open for longer. However, we believe we are at or close to a tipping point in the terms. When it tips, the terms can change very fast.
The impact of artificially low interest rates
Our recent post The Break-even Year for equities makes the point that with negative real risk free interest rates (the product of QE) the expected equity 'risk premium' is as high as we normally associate with deep bear markets. The Fowler Drew model for real equity returns has a break-even year at 95% confidence only 7 years out, versus 25 years normally. The Break-even Year is when essentially all of the probable outcomes of a diversified mix of equity markets lie above the risk free rate. ILGs are the closest match to the nature and reliability of a Defined Benefit (DB) pension so they are the right risk free asset. Logically, you need to be extraordinarily averse to the short-term risk of equities to prefer an ILG-backed pension over a partially equity-backed pension in these conditions.
It made perfect sense, when the expected break-even was long as 25 years, to prefer the certain real outcome of a DB pension over the uncertain outcomes of a personal pension, or Defined Contribution (DC) pension (otherwise also known as a Money-Purchase arrangement). Too much of the distribution of probable outcomes of a drawdown plan would lie below the DB pension. The DC member bears all the capital-market risks, the inflation risk and the risk of outliving their capital and all three contribute to the distribution of the uncertain real outcomes from a personal pension. The DC member also bears all the costs of managing these risks. Only in exceptional circumstances, such as being concerned about the credit risk of the DB sponsor when there is still some time before retirement, particularly if the pension entitlement is large, or when a sponsor is very keen to lay off particular liabilities, would a transfer from DB to DC be obviously better for anyone with normal risk aversion. This is reflected in the regulator's rulebook which tells advisers to start by assuming a transfer is not suitable. The Financial Ombudsman, believing it acts for a risk-averse constituency, will start from the same assumption and will not be easily persuaded that a transfer was in the client's best interests. Even advisers with the required qualifications to handle pension transfers have therefore been wary of recommending them.
QE has transformed this logic. This is because the Cash Equivalent Transfer Values offered by many DB schemes, the amount of which is not a whim but is bound by a set of fairness rules overseen by actuaries, are driven up by lower interest rates in exactly the same way that the risk free rate for a private portfolio has been driven down, whereas the expected returns from risky assets have not been reduced in the same way. So when appropriate expected returns and risks are applied to the transfer amount, it is much easier to justify even a risk-averse investor being better off. It is not even necessary to bring not account the benefit of other 'optionality' they may value, such as higher income for a surviving spouse, lightly-taxed death benefits in the event of early death and substituting all or some of this capital to support retirement spending by other capital that would otherwise be subject to IHT.
Modelling the DC alternative
By 'appropriate' returns and risks we mean a range of probable outcomes with a realistic 'distribution' - i.e. a range of possible outcomes that is as compete and accurate as can be. To be realistic it must reflect the true sources and levels of uncertainty affecting a long-lived investment programme. But it must also allow for i) the many different time horizons involved in a drawdown plan ii) the time dependence of both capital-market and inflation risks and iii) a suitable framework for derisking the portfolio as the overall plan duration gets shorter with age. Our modelled approach to drawdown allows this simulation of the outcomes of the plan, specific to every individual plan. Because it incorporates a risk-management discipline varying with age, the distribution is bound to be different from the projected outcomes of a 'buy-and-hold' portfolio with a constant asset allocation, which is what you are probably used to seeing.
The FCA neither encourages not discourages the use of 'stochastic' or probabilistic models, such as Fowler Drew's, to stress-test the transfer decision. The fact is that hardly any advisers have this capability. This is unfortunate, as no other approach to the comparison of benefits can come close to giving clients enough information or in a form they can readily relate to.
All advisers will meet the regulatory requirement to calculate (usually with off-the-shelf software) what return is required in any intervening period up to retirement to purchase an annuity equivalent (in form and amount) to the pension benefits. This is clearly academic if the reasons a transfer is in the client's best interests are ones that preclude an annuity purchase. However, advisers are also required to compare the DB pension with the same level of draw from a personal pension. They will usually do this by referring to the FCA's prescribed illustrative growth rates (what the regulator
calls Standardised Deterministic Projections). The way that is usually expressed is as the duration of the capital: how long before it runs out. If on low illustrative real growth rates, after the impact of product costs, the DB income would be closely matched or exceeded into a ripe old age, a transfer is likely (subject to individual risk aversion) to be in the client's interests; whereas, if it takes what by historical standards would be a high growth rate to make the capital last long enough, a transfer must be hard to justify. Disregarding for the moment the controversies around the actual rates prescribed by the FCA and the issue of applying them to a portfolio with derisking (rather than buy-and-hold), the effect of QE has been to give more advisers confidence they can justify a transfer relying on the centre ground of the FCA ranges.
Tax changes favour transfer
Though it is QE that has mainly transformed the logic of transferring, tax changes brought in by the previous Government have greatly increased the value of the 'embedded option' in a drawdown plan in respect of death benefits. Whereas benefits passing to a wife (or 'bypass trust') on death before age 75 were always tax free, death benefits can now be passed at any age without tax to spouse or descendants, being taxed only when distributed as 'income'. This effectively turns a personal pension fund into an 'excluded property trust'. Like any capital excluded from death taxes, the fund is therefore the last asset to be consumed, as long as there are other assets that can be consumed first.
If there are other assets able to replace both the DB pension and a pre-existing SIPP, the appropriate comparison of benefits is not with the personal pension scheme into which the DB transfer value is moved (because that will not be drawn down) but rather the other assets which, not being pension assets, will also be taxed differently. The comparison with the DB pension in this case calls to be made on a post-tax basis (both lifetime and death taxes) which will further weight the outcomes in favour of transfer.
A worked example
In the chart below we show three alternatives based on a recent specific case. The transfer value has been rounded up to £1m, for a pension with a current value (two years before normal retirement age) of £33,000.
The first column shows the current deferred pension value, gross per annum. The spouse pension will be cut by half on the death of the member but this is not shown. Otherwise this DB pension has virtually no uncertainty about it's future level in real terms.
The second column replicates how a comparison with a SIPP drawdown plan might be made without proper modelling. It outputs three draw rates from the transfer value, as an annualised equivalent gross pension amount, all of them solved for to avoid running out of capital before age 100 and each applying one of the FCA's prescribed real rates: 0.5%, 2.5% and 4.5% pa. These have been reduced by costs of 1.25% pa (to be consistent with ours rather than typical of industry charges for drawdown). There is no confidence level associated with either of the three prescribed rates. They describe differences in risk level assumed rather than differences in market conditions experienced. The FCA's lowest rate is probably only applicable if assuming low-risk and low-return assets are held but in that case, the security of the DB pension would always be preferred. The upper half is by implication applicable for drawdown but our model suggests it understates the true downside risk.
The third column is Fowler Drew's modelled distribution of possible sustainable real income, or capital surplus expressed as equivalent annualised income. The real income level is also constrained to ensure the capital will last to age 100. The range of probable outcomes reflects a typical level of risk aversion. The worst outcome income level, the bottom of the column, has a 99% chance of being exceeded. The best outcome has only about 1% chance of being achieved. Any outcomes much above 50% (£39,500) - the centre of the column - would probably be enjoyed as capital surplus rather than additional income as long as the draw rate at every stage was still based on a high level of confidence it could be sustained. For the same reason the actual draw recommended would be closer to the bottom than the middle of the distribution, unless a deliberate profiling of the income through retirement was chosen.
Before costs associated with the personal pension, all of the the outcomes from the FD simulation are better than the DB pension. That is a measure of the effect of QE. After costs of 1.25%, our model shows the break-even income level has a 91.5% chance of being exceeded. In other words, there is a 8.5% chance of a shortfall. On a worst-case basis that shortfall could be equivalent to £4,100 pa. Though the relationship between the area of outcomes higher and lower than the DB pension is a clear and intuitive measure of a client's risk attitude, some clients will be willing to weigh against the shortfall risk not just the gross income upside but also other benefits or options, such as higher spouse income, probable tax savings and the possible capture of death benefits. These can only be assessed and quantified case by case.
May we help you?
The transfer logic in this example is exceptionally compelling because of capital-market conditions resulting from QE. But every situation has its own idiosyncratic features and needs to be analysed in detail. You will need help quantifying the value of the options provided by a transfer. It's never a 'no-brainer' because it never only involves the brain: this is a step change in risk which may require emotional interpretation. All this is what we do.
The actual outcomes of a transfer will depend on the management approach to the drawdown portfolio that replaces the DB pension and whether it is able to deliver the agreed plan within identified constraints. Is it only an exercise in target setting or are the targets deliverable? In our case, the same model that is used to inform the decision about transferring is used to manage the assets in the retirement plan following a transfer, including the combination with any other assets you assign to meeting retirement spending, and including the state pension as a contribution to your spending targets. Though most of these plans have a life much longer than we have been in existence, the modelling originally developed in 1998 has since been tested in some extreme actual market conditions (the tech boom and bust, Japan, the credit crisis) without the model assumptions being breached.
What you will pay also matters. As you can see from the example, the chance of a shortfall is highly sensitive to the cost assumption. It is only because our process is systematic that we are able to keep costs as low as the 1.25% in the chart. And in our case, charging flat fees rather than portfolio-based fees, the chance of a shortfall is even lower for a client with total financial assets that are greater than the £1m transfer value. With total costs (ours, custody, the investments) equivalent to 0.75%, for instance, the shortfall risk drops from 8.5% to 2.1%.
To discuss a possible transfer with Fowler Drew, please call my colleague David Anderson who is our transfer specialist.