Everyone's a winner: the best way to transfer out of final salary schemes

One of the tactics for reducing final salary pension scheme liabilities is to offer selected members (usually the more highly paid ones) a package deal to transfer out of the final salary scheme.

There are some difficulties with this option, since companies want to achieve the transfer out of the final salary plan without leaving themselves open to any subsequent litigation from disgruntled employees.

One obvious ground for legal action would be that the option they took had not been properly explained to them and that they were put at a disadvantage in comparison with the benefits they might have enjoyed had they stayed in the final salary scheme.

The usual technique for dealing with this problem is to ensure employees who are offered a transfer package are given access to a competent independent financial adviser to explain the merits of the deal on offer.

Slimmed-down liability
For some time, a transfer-out deal was regarded as quite a good way of ‘slimming down’ the scheme’s liabilities. However, as Clive Fortes, head of corporate consulting at Hymans Robertson, observes, companies are less enthusiastic about this option than they used to be. In part, this is because the yield on corporate bonds has been rising, reducing the value of the pension scheme liabilities. That has taken away some of the urgency for conducting transfer exercises.

A second point, Fortes says, is that in the past few years corporates have been able to offer enhanced transfer values, where the employee got more than they actually had in the pension scheme as an inducement to leave it. They could do this at less than the liability cost to the fund of keeping that member in the fund, as measured by IAS 19. Today, with rising bond yields, that is no longer possible.

Although companies have to proceed with care in this area, Fortes argues t here are plenty of scenarios where a transfer can be a good decision for both parties. He cites the following example:
• A reasonable cost to a company of buying out a £10,000-a-year index-linked pension for some currently aged 45 would be around £200,000.
• If the member took that £200,000 and invested it in a way that generated a return 1% greater than government gilts, on retirement in 20 years they would probably end up with a higher pension than they would have had from the final salary scheme.
• If the company only offers 80p in the pound (ie, £160,000), then a return of 1% over gilts on that money would only match the original scheme benefit.
• If, however, the company offered just 50p in the pound (£100,000) ­ a level which is probably closer to what companies would actually offer ­ the member would need a hefty 3.5% a year more than gilts to match the final salary benefit.

“If the company can get rid of the liability at less than the full actuarial buyout cost an insurance company would demand, and the member can get a better pension from the transfer payment, then that is really a win-win for both sides. However, if the level of enhancement is more modest and is designed in a way to entice the employee to take the cash, then you need the member’s IFA to be asleep at the wheel for the deal to go through,” he says.

Flexible benefits
There are other factors, though, for the employee and the IFA to consider over and above the sheer cash value of the transfer. First, Fortes points out that opting out of the scheme for a substantial payment gives the employee much more flexibility as to the timing of when they decide to retire, be it early or late. Something else to think about is that if the company’s future seems uncertain and its markets are potentially going against it, then crystalising the value of the pension and moving on makes excellent sense.

As a final point, the mathematics makes it much easier to make transfer options work for members in their early-40s than it does for older members. This is because younger scheme members have enough time before their statutory retirement date to replicate the benefits of the final salary scheme in their own private pensions vehicle. Very young members, however, such as those in their 20s, won’t yet have built up enough value in the scheme to make a transfer worthwhile for them.

So, provided the company communicates the whole thing properly and has a decent quality of financial advice to hand for the employee to consult, then the company has a defensible position in law, says Fortes. This will give transfer values their proper place in the armoury when it comes to managing pension liabilities.