Advisers must work out a ‘transfer value comparator’ to determine value for money in final salary pension transfers. Steve Webb explains how it works.
In the last couple of years more than 200,000 people have taken the big decision to transfer the rights they have built up under a final salary pension scheme into a different sort of pension arrangement. But how do you know if the amount of money you are being offered in exchange for your old pension is good value?
Until recently, financial advisers were expected to calculate something called a ‘critical yield’ as one way of measuring the generosity (or otherwise) of the transfer value you were being offered. This calculation was in two parts. First, the adviser had to work out what target pot of money you would need at retirement in order to buy an annuity that exactly matched the salary-related pension you were giving up. Second, they worked out how much your actual transferred amount would need to grow each year in order to deliver that target pot size. This annual percentage increase was known as a ‘critical yield’.
Calculate expected returns
The purpose of this calculation was to give an idea of the investment return you would need on the money you had transferred in order to match the benefits you were giving up. If you only needed to achieve a few per cent a year in investment growth (a low ‘critical yield’), then you might be confident that you could get at least as good an outcome as before you transferred, without taking much investment risk. But if the critical yield figure was high, this was a warning that you might have to take a lot of investment risk simply to replicate the value of the pension you had given up.
Many people found this idea of a critical yield to be rather confusing, and in response the Financial Conduct Authority (FCA) has now changed the rules with effect from this month (October).
In future, advisers will have to present you with something called a ‘transfer value comparator’ or TVC. The TVC is a lump sum figure which is designed to show the ‘true’ value of the pension you are giving up, based on certain strict assumptions. You can then compare this with the actual transfer value you are being offered. If the transfer value on offer is well below the ‘true’ value of the pension, you might want to ask searching questions about whether you are getting good value.
The way the TVC is worked out is in some ways similar to the critical yield, but the result is presented as a lump sum rather than a percentage. The starting point of the calculation is, as above, to work out how large a lump sum you would need at retirement to buy an annuity that matchs the salary-related pension you are giving up. But the second stage is to work out how large a pot you would need today if you were to invest it on a riskfree basis, to deliver the target lump sum at retirement. That estimated pot is the TVC figure.
The FCA will expect advisers to present this information in the form of a bar chart with one bar showing how much you have been offered for your pension and another bar – usually higher – showing the ‘true’ value of your pension.
When to transfer
However, just because the TVC calculation suggests that you are not getting full value for your pension does not mean a pension transfer is a bad idea. Indeed, the Pensions Regulator recently wrote to more than a dozen pension schemes asking them to look at whether the transfer values they were offering were too generous. This is because a lot of people taking large transfer values out of a scheme which is running a deficit could leave the remaining members in a difficult position if the sponsoring employer were to go bankrupt.
Whether or not a transfer represents ‘good value’ is ultimately a very individual decision. For some people, the main attraction of a transfer is the freedom to use their savings in a different way, and they are willing to give up some of the value and certainty that they had in their old pension scheme. Ultimately, the key when considering a pension transfer is to go in to the advice process with an open mind and to be willing to follow the advice that you receive.
Steve Webb is director of policy at Royal London.