Fiona Matthews explains the benefits of allowing members to transfer out of their DB scheme

There has been a significant amount of focus in the pensions press in recent years on the advantages of DB schemes over DC schemes. But arguably some of the advantages of DC schemes, such as the additional flexibility for members surrounding their choice of benefits, have not been as well publicised.

Options such as pension increase exchanges, which have now become fully integrated into the pensions landscape, have given members of DB schemes some choice over the form of their retirement benefits but this is limited to the option to swap (for a flat pension) the parts of their inflationary-linked pensions that built up before April 1997. Unless members are prepared to transfer their benefits some years prior to their retirement to a DC pot (and accept the associated risk in relation to investment returns), they won’t have any choice about the form of the spouse’s benefits or the ability to exchange increases on post 1997 pensions. One option that DB schemes are beginning to consider is to go beyond their statutory obligations and allow members to transfer their benefits in the year before retirement. This provides the necessary flexibility but doesn’t bring with it years of pre-retirement investment risk for the member. One additional attraction for the member is that the tax-free cash sum available under the DC scheme is often higher than that available under the DB scheme. The cash sum can be further boosted for those members who meet the new Minimum Income Requirement (MIR). For members in poor health or who are smokers, the DC route will also provide the option to purchase an enhanced annuity.

Of course, from the employer’s perspective, this is an attractive proposition too. The transfer of benefits from the scheme means the removal of the mortality and investment risk associated with those members. In addition, if members transfer rather than draw their pension from the scheme, the term of the pensioner liabilities will be reduced and it should be easier for schemes to find bonds of the necessary duration to match these liabilities. For the increasing number of schemes where the end point of a long-term journey plan is to buy out their liabilities with an insurance company, this represents a step along the road to achieving this goal and can potentially bring the end point closer. Indeed, it can provide a neat fit with other risk management exercises, such as an early retirement exercise. Finally, the transfer of members is likely to have a knock-on downward impact on the scheme-based PPF levy and future administration costs.

That is not to say that there aren’t a number of considerations that the trustees and employer need to carefully work through in order to decide that this is an appropriate option to offer to the scheme’s membership. They will need to be happy that the members selecting this option won’t just be those in poor health, leading to selection against the scheme, which may ultimately increase costs and potentially make the scheme less attractive from an insurer’s perspective. Our initial impressions are that, if carefully communicated, such options are likely to appeal to the whole pension population, not just a specific subset of the membership. In particular those who satisfy the MIR may be attracted by the ability to access a series of taxable cash sums as and when they are wanted. These members account for a disproportionate share of the scheme’s liabilities and longevity risk and will help to offset the impact of smokers leaving.
Inevitably, the pension due under the DB scheme rules will be a powerful reference point and ‘sticking with what I have’ will be the default choice for many members. Choices can be confusing and so the provision of independent financial advice to members should be a critical part of any such offer at retirement. Not only will it satisfy the trustees that the at-retirement options meet the principles of the Code of Good Practice, but by helping to educate members on the options available outside of the DB scheme the proportion of members who transfer, to get benefits which suit their circumstances better, is likely to be increased.

Written by Fiona Matthews, senior consultant at Towers Watson

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