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Joseph Mariathasan: The implications of DB transfers

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A friend of mine with a deferred pension of £20,000 a year from the now-defunct ICI decided to explore what the transfer value would be if he chose to move it to a self-invested personal pension (SIPP). To his amazement and delight, he has been quoted a figure of £700,000, a multiple of 35 times his annual pension.

ICI is not unusual. Aviva has been offering 39 times the value of a pension, while Barclays has been offering 41 times.

For my friend and others, it can be a no-brainer. Taking his £700,000 and putting it into the Vanguard FTSE All World High Dividend Yield fund with a current yield of 3.25% would give him a pension of £22,750 - higher than he would have got from his defined benefit (DB) scheme. Putting it into the Henderson Far East Income fund with a current yield of 5.7% would give a pension of £39,900, almost double his DB pension.

I am not recommending he does either, but the reader can get the general idea. The dividend yields of equity funds can far surpass the income available from an annuity.

Of course, dividends can go down in any year, but over many years they would be expected to keep up with inflation. There will be capital fluctuations of course, but if he has no intention of ever making a sale, capital volatility is irrelevant.

The biggest attraction for him, however, is not the increased pension he would be able to generate, but the fact that a DB pension is an annuity. This means that if he dies, his wife may get a fraction of his pension. Once they both die, the DB pension disappears. In contrast, the full £700,000 plus any appreciation in its value over the rest of his lifetime of his SIPP (after drawing down income from it) would be available to pass onto his children.

It is easy to see why pension schemes are willing to offer such attractive terms to deferred pensioners. The ultimate goal of derisking a closed pension scheme is to buy a bulk annuity, which removes all liabilities from the corporate sponsor. The pension scheme liabilities are valued on the basis of risk-free nominal and index-linked gilts. With demand overwhelming supply, index-linked gilt yields have turned negative, prices have gone sky high, and annuities have become very expensive.

Conversely, a deferred pensioner effectively selling his future annuity back to the pension scheme can get a very generous deal. This situation is unlikely to change quickly, with real yields still kept low by the massive demand from pension schemes for gilts with which to derisk their portfolios.

Despite DB transfers of this type leading to what appears to be a win-win situation for both deferred pensioners and the pension funds themselves, the situation does raise a number of questions.

The most obvious would be: What happens if everyone who can take up the offer, does? Does the scheme in question have sufficient funds to pay 39 or more times the pensions due for everyone? If they do, are they possibly overfunding the pension scheme?

The argument that is often made is that as schemes mature into negative cash flow in a run-off, the investment problem changes into a cash flow matching and liquidity issue. The risk for a particular scheme is that it won’t have enough money for the youngest members if it invests in equities, despite them giving higher yields. But the focus on eliminating that risk has ultimately led to the demise of DB pension schemes as bonds have become so expensive.

What is good for a scheme – and for an individual within that scheme who takes up the opportunity today of transferring a DB pension – is not necessarily good for society at large. The focus on treating pensions as a liability that has to be matched has forced most DB pension schemes to close to new entrants. As a result, the lucky DB deferred pensioners aged over 50 may be able to benefit today, but society has been left with new generations in less generous defined contribution pension schemes who will struggle in the future.

It does seem a hard price to pay because no one could think of a way to guarantee a long-term return equal to gilts whilst investing in equities. Perhaps that is what a UK sovereign wealth fund should be doing.

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