The Great Pension Debate – Are Critical Yields Still Relevant?
Pensions have become far more flexible and tax efficient over the past 10 years leaving us with an effective tax and estate planning vehicle. However, this leads to the question, what role does a Critical Yield now play in deciding the suitability of transferring out of a Defined Benefit Pension Scheme?
To find the answer, get a full understanding of what a Critical Yield is (and unpick the jargon along the way) our best starting point is with the most common type of pension scheme.
Defined Benefit Pension Schemes
The best example of a Defined Benefit Pension Scheme is a Final Salary Pension. Simply, this scheme offers a guaranteed, inflation adjusted income that, once started, will continue for the rest of the client’s and client’s partner’s lives. It may also include a lump sum upon retirement.
For most of our clients, a Defined Benefit Pension Scheme is the ideal pension solution. However, there are those who want to explore their options before committing to a once-in-a-lifetime pension scheme decision, even if it is just for peace of mind.
The alternative to receiving defined benefits through a Defined Benefit Pension Scheme is transferring the ‘Cash Equivalent Transfer Value’ to a Personal Pension.
This is where jargon – and calculations – can start to muddy the water.
What is a Cash Equivalent Transfer Value (CETV)?
A CETV represents the expected cost of providing a member’s benefits within a pension scheme.
In the case of a Personal Pension, this is generally straightforward – it is the accumulated contributions made by and on behalf of the client together with investment returns.
In the case of defined benefits, the CETV is a value determined on actuarial principles which requires assumptions to be made about the future course of events affecting the scheme and the client’s benefits.
The simple way of looking at this is working out what the lump sum of money needs to be in order to secure an income via an annuity equal to what would be provided by a Defined Benefit Pension Scheme.
Each Defined Benefit Pension Scheme will use different assumptions when making these calculations which can lead to very different lump sums i.e. CETVs.
The questions are, does the CETV represent good value, is a scheme offering a generous CETV or does the CETV represent poor value? To find this out a calculation is required and this is where Critical Yield comes in.
Introducing Critical Yield
Critical Yield is the estimated investment return, after charges, that must be achieved in order to receive retirement benefits at least as good as those offered by a Defined Benefit Pension Scheme. This is normally achieved through the use of a Transfer Value Analysis System, or TVAS.
TVAS is an automated system which calculates the investment return required from a Personal Pension fund to provide the same benefits as those given up by transferring. The system is dependent on demographic and economic assumptions which are stipulated by the FCA in their handbook detailed in COBS.
This is where the assistance of a Pension Transfer Specialist comes in. It is their job to help our clients analyse the CETV, taking into consideration personal needs and financial circumstances.
Once that’s done and carefully documented we can then help clients consider the costs of moving, the potential benefits gained or lost by moving and the required Critical Yield which will determine whether moving from a Defined Benefit Pension Scheme represents good value or not.
Critical Yield Assumptions
As mentioned before, there are various assumptions that have to be taken into consideration for us to be able to calculate the Critical Yield of any given transfer. These currently are:
- Annuity rates
- Revaluation rates to be applied to the benefits through to the member retirement date
- Indexation/escalation rates for the benefits once they come into payment
For example, an increase in the annuity interest rate would mean that the amount of capital needed to provide the same annuity would decrease and the Critical Yield would decrease. If mortality improves then the Critical Yield would increase.
A key point is that meeting the Critical Yield does not guarantee matching benefits. For benefits to match, all assumptions need to be met identically.
The Critical Yield could be exceeded and benefits not matched if the other assumptions are not met. Conversely, the yield may not be achieved but benefits matched due to a compensating change in other assumptions.
The assumptions are by their nature subjective and likely to change as they include matters such as expected inflation and changes in average earnings.
Critical Yield – an example.
To highlight what a Critical Yield is in simplified terms, here’s an example.
– Tom has a Defined Benefit Pension Scheme (Final Salary Pension) with IBM.
– He has had a letter telling him he will receive an annual income of £20,000 per year starting on his 65th birthday which is in 5 years’ time.
– His pension will continue on his death for the balance of 5 years from commencement and then 50% to his spouse.
– The income will rise each year in line with RPI.
This is all very well but Tom would like to find out whether it would be to his advantage transferring the ‘cash equivalent transfer value’ to a Personal Pension.
– Tom requests a CETV which confirms a value of £350,000.
– Using simple figures, we assume the scheme pension rises by 2.5% per annum over the next 5 years and therefore would rise to £22,628.
– If the CETV is transferred to a Personal Pension and a 3% (£10,500) fee is applied, then the value of the Personal Pension would be £339,500.
– If the value of fund then grows by 7% per year over the next 5 years but charges reduce this by 1.5% per annum to 5.5% then in 5 years’ time the Personal Pension would be valued at £443,713.
– If annuity rates for a 65-year-old male, with a 50% spouse’s pension provide an annuity rate of 2.8% then the Personal Pension valued at £443,713 would provide an income of £12,424. i.e. £443,713 x 2.8%.
– This is well below the guaranteed income being provided by the current Defined Benefit Pension Scheme.
Where Critical Yield comes in is calculating the rate of growth required to match Tom’s projected Defined Benefit Pension Scheme income of £22,628 per annum.
For this to be advantageous, the Personal Pension value must equal £22,628 ÷ 2.8% = £808,143 in 5 years. Therefore, the Personal Pension plan would need to grow at 18.9% after charges, giving a Critical Yield of 20.4% per annum.
Critical Yield and Annuity rates
Annuity rates are historically low at the moment due to a number of factors including people living longer and gilt yields being driven down by low interest rates and quantitative easing.
A rise in annuity rates of 2% in Tom’s example would make a huge difference.
– £22,628 ÷ 4.8% = £471,417. Reducing the rate of growth required after charges to 6.79% from 8.29%.
The basic calculation to work out a Critical Yield uses a ‘standard’ annuity rate. Many people could benefit from enhancements to the annuity rate they receive due to their health or lifestyle factors which may reduce their life expectancy compared to the ‘standard’ person.
When you combine this with the potential for annuity rates to rise in the future from their historic lows you can quickly see how the calculation can be deemed as flawed.
It is important to note that not everyone will receive an enhancement and the fall in annuity rates could be here to stay and not be a short term trend.
Critical Yield/Calculations/Assumptions – What about the individual?
What the Critical Yield calculations cannot possibly take into account is the individual and their wider financial circumstances, objectives, health, income needs, lump sum needs, taxation position, financial dependents, financial knowledge, experience and attitude to investment risk.
When we used to consider a ‘Pension Transfer’ from a Defined Benefit Pension Scheme to a Personal Pension clients were ultimately forced to use part of their CETV in certain ways and did not have full flexibility.
– They would have to buy an annuity once they reached age 75.
– They would have to provide death benefits to a spouse in the form of an annuity with the ‘protected rights’ section on death.
– The value of any residual fund on death would have highly penal tax charges applied if drawn as a lump sum by loved ones.
With the introduction of Flexi-Access Drawdown (FAD) and its removal of the need to consider maximum Government Actuary’s Department (GAD) limits, the opportunity to take large, irregular and ad-hoc income payments creates further complexity in ensuring the sustainability of a client’s pension income.
These changes all have an impact on Critical Yields when assessing clients’ circumstances.
So, are Critical Yields still relevant?
A Critical Yield still provides a good yardstick when trying to understand if a CETV provides good or bad value. In addition, where an individual wants the security of a guaranteed future income, again the Critical Yield shows the level of growth required to match this.
However, if a member wants an income similar to that provided by a Defined Benefit Pension Scheme, transferring out of a Defined Benefit Pension Scheme to a Personal Pension (incurring charges and investment risk in the interim) is unlikely to be in our clients’ best interests.
When considering whether, or how, to use Critical Yields it is worth exploring other ways of identifying a drawdown income’s sustainability. Examples of alternatives might include using a cash flow modelling tool or by identifying and commenting on the number of years before the pension fund is likely to be exhausted.
Overall, for any pension scheme, income stability is key. For clients to achieve this, whether through a Personal Pension or Defined Benefit Pension Scheme, requires professional analysis including a Critical Yield calculation.
And this is where the expertise, knowledge, technology, performance and resource of a great and appropriately qualified and experienced financial adviser comes into play.
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Blog published by Mike Coady