We consider issues relating to pension transfers from DB to DC schemes and the use of the pension freedom reforms. What will 2018 hold for consumer protection in this regulated environment?
In this article, we consider current issues relating to pension transfers and the use of the pension freedom reforms. We also look at what 2018 holds for possible improvements to consumer protection in this regulated environment.
Background to pension freedoms
The pension world changed in April 2015. With the introduction of pension freedoms, consumers were given unprecedented control over their defined contribution (DC) pension savings.
For the first time, savers aged 55 or over were permitted to access their entire DC savings via various flexible options. This included the option to make one or more lump sum cash withdrawals – 75% of which would be charged at the marginal rate of income tax and 25% would be tax-free. The norm of purchasing a lifetime annuity came to an end (but remains a possibility).
The main driver for pension freedoms was ideological: working individuals who have saved over a lifetime should have access to their savings or be able to invest them as they wish. There was also a financial driver: the historic annuity market was thought to be providing poor value for consumers in retirement.
To access pension freedoms, members of private or funded public sector defined benefit schemes (DB schemes) have to exercise their statutory right to transfer (or otherwise be permitted to transfer under the scheme rules) the transfer value of the defined benefits ('DB benefits') into DC schemes pursuant to Part 4ZA, Pensions Schemes Act 1993.
The key concern in this scenario is that if a DB scheme member is poorly advised or, worse, the target of a pension scam, valuable DB benefits could be lost and not replaced with alternative benefits of the same security or value. At a certain level, the risks associated with providing benefits switch from the sponsoring employer of the DB Scheme to the member themselves. The member loses the support of the employer, which can be compelled by the Pensions Regulator. The member also loses the benefit of the DB Scheme’s professional advisors and the ultimate protection of the Pension Protection Fund should the employer fail.
Concerns about DB to DC transfers
In the consultation around the introduction of pension freedoms, the main concerns about meeting member requests for transfers from DB to DC schemes were the mis-selling risk and the potential negative effect on remaining schemes.
Following the government’s consultation, it anticipated that the number of transfer requests from DB to DC schemes would reduce because offered transfer values were often less than the ultimate net value of the DB benefits in retirement. The government recognised that for most individual members of DB schemes, retaining membership of a DB scheme is likely to be the best option given the level of security and guaranteed indexation that DC schemes do not offer. This remains the position in The Pension Regulator's guidance for DB scheme trustees to manage transfer requests and their impact.
However, the government concluded that such a transfer would sometimes be in the individual’s best interests including the heavily indebted, those with short life expectancy, those who were unmarried without dependants or those that would prefer capital to income.
What safeguards are in place?
The government appeared to be persuaded by industry to continue to permit transfers of DB benefits into DC schemes as being ‘in keeping with the freedom and choice principle of the reforms’.
The government noted that this decision was justified because the estimated transfers out of DB schemes would be between 10% – 20% (but were expected to be less than 10%, because existing pensioners would be excluded from the transfers out of DB schemes and because in all likelihood transfers out would be near retirement and spread over a number of years). In order to protect consumers, the government created two main safeguards:
- The requirement that the trustee must check that the member has taken advice from a professional financial advisor who is independent from the DB scheme and authorised by the Financial Conduct Authority (unless the value of the transfer is under £30,000). Advice requirements for trustees and managers are set out in secondary legislation (the ‘independent advice requirement’).
- The Pensions Regulator has given guidance for trustees on complying with the advice requirement when receiving a transfer request from a member, and on the use of their existing powers to delay transfer payments and to take account of scheme funding levels when deciding on transfer values (the ‘Regulator’s guidance for trustees’).
Independent advice requirements
The Pensions Regulator’s Codes of Practice and Regulatory Guidance do not need to be followed in every circumstance. However, trustees must ensure that any deviation still meets the requirements of the underlying legislation. In relation to the independent advice requirement, the guidance includes the following:
- It is likely (although not in every case) to be in the best financial interests of the majority of members to remain in their DB scheme.
- Before the trustee makes the transfer or conversion, the trustees are required to check that appropriate independent advice has been received by the member including those matters set out in paragraphs 37 to 44 of the guidance (but not that the advice was correct or that it was followed).
On the same day in July 2014 as the government published its response to the consultation on freedom and choice, the FCA published a thematic review on Enhanced Transfer Values. The FCA's review identified a risk of consumers losing out on retirement income due to poor advice from IFAs and summarised examples of good and bad advisory practice.
The report cited the proposed pension freedom reforms and ‘the temporarily heightened risk of unsuitable transfers’. In a third of the cases examined by the FCA relating to bulk pension transfer advice between 2008 and 2012, the advice given to consumers who were offered enhanced transfer values as an incentive to leave a DB scheme was unsuitable (although the failings were not equally spread across firms).
Key reports and updates
FCA retirement outcomes review interim reportJuly 2017
Fast-forward to 2017, and the practical effect of the independent advice requirement for DB to DC transfers can be questioned. The FCA’s Retirement Outcomes Review: Interim Report in July 2017 stated that over 53% of DC pots accessed since the 2015 pension reforms were fully withdrawn and 90% of those were below £30,000. To the extent that any of these originate from DB to DC transfers, the independent advice requirement would not bite on a large proportion of these transfers because it does not apply to transfers under £30,000.
Accurate information about the number of transfers out of DB schemes into DC schemes since 2015 is scarce. The FCA has introduced new rules on the collection of pension freedom data, which will include the reporting of information about DB transfers. We should have a clearer picture for the period from 1 April 2018, which will be reported on within 45 days of 30 September 2018.
In addition, the FCA found that accessing pension pots early has become ‘the new norm’. 72% of pots have been accessed by consumers under 65. Over one million DC pension pots have been accessed since 2015.
While the Interim Report did not focus on pension transfers, some of those examples reviewed by the FCA are likely to have originated from DB to DC transfers. Broadly speaking, the FCA’s interim findings were that pension freedoms have been welcomed by consumers and that, while the market is still developing and firms and consumers are continuing to adjust to reforms, FCA identified five emerging issues relating to mistrust of pensions by consumers, consumers choosing the path of least resistance, consumers drawing down without advice, competition of the market and limited product innovation.
However, of those contacted by the FCA, 94% of consumers who fully withdrew their DC savings had other sources of income in addition to the state pension. While drawdown has become much more popular (and twice as many pots move into drawdown than annuities), of those drawdowns, 14% used the largest share to pay off debts, 25% spent the largest share or all of it (e.g. on home repairs or a car), 32% saved the largest share and 20% invested the largest share in capital growth (e.g. property or investments in bonds, stocks and shares or a business).
The FCA’s Final Report is expected in Q2 2018.
Work and pensions committee inquirySeptember 2017
In September 2017, the Work and Pensions Committee announced the ‘pension freedom and choice inquiry’ into whether and how far the reforms are achieving their objectives and whether policy changes are required. This is against a backdrop of police figures that suggest that £43 million in pension savings have been fraudulently misappropriated since 2015.
The scope of the inquiry includes considering whether the government and FCA are taking adequate steps to prevent scamming and mis-selling. The launch page of the inquiry notes that the threat has been more pronounced since the 2015 pension freedoms reforms gave people more flexibility over access to their DC savings. The consequences of a scam for individual households can be disastrous: the loss of a lifetime’s savings with little chance of getting them back.
Work and pensions committee reportDecember 2017
On 10 December 2017, the committee published a report entitled ‘Protecting pensions against scams: priorities for the Financial Guidance and Claims Bill’. The report welcomes the government’s commitment to banning cold calling and concludes that while the pension freedom reforms are broadly welcome, they have undoubtedly made many savers more susceptible to being scammed and that:
“scamming is likely to be grossly underestimated by official reports and its full scale may not be apparent for many years. For the victims, the loss of a lifetime’s saving can be devastating. It is a problem that warrants urgent action.”
In this context, some people are questioning why the FCA is consulting on the proposition that advisors should not start from the existing assumption that a DB to DC transfer would be unsuitable. The FCA Policy Statement is expected in Q1 2018.
FCA defined benefit pension transfersOctober 2017
The FCA published an update on DB pension transfers on 3 October 2017. The FCA acknowledges that the number of consumers transferring from DB schemes to personal pensions has significantly grown over the past year and that some firms are not giving enough attention to customer outcomes.
This interim review found that 17% of recommendations to transfer out of DB schemes were unsuitable and 24% of recommendations for a product and fund were unsuitable. In addition, in 36% of transfer recommendations, it was unclear that it was suitable and in 40% of recommendations relating to a product or fund, it was unclear that it was suitable.
In the overall context of increasing requests for DB transfer quotations, and the proportion of these that are being transferred, this is concerning. In its Q2 review 2017, LCP reports that a third of transfer quotations were paid out, which is the highest since LCP started its analysis in Q1 2014.
Issues for trustees of DB schemes
The risk of pension liberation and the increasing number of transfer requests since the pension freedoms have caused a dichotomy between the DB member’s statutory right to transfer and a DB scheme trustee’s duty to act in the best interest of the member. This dichotomy is heightened in circumstances where the member is required to obtain the advice of an IFA but decides not to follow that advice.
These issues culminated in the High Court decision in Hughes v Royal London, where the specific issue was whether the member was entitled to transfer – a decision that depended on the interpretation of ‘earner' in relation to the receiving scheme. The case is considered to have wider impact however as it confirms (notably in the Pensions Ombudsman’s view) that under the current legislation, trustees cannot refuse such a transfer “even if they have significant concerns that it may be for the purposes of pension liberation”.
The Pensions Liberation Industry Group has developed a Code of Practice, including detailed guidance to administrators and trustees on what due diligence to carry out, and what to do if the trustees decide not to make a transfer (which may include reporting their own breach of law to the Pensions Regulator). Ultimately, however, without changes to the law, this remains guidance only.
A transfer out of a DB scheme will be suitable for some; for many more, it will not be.
The FCA is considering how to get ‘the market on a good footing for the future’ including additional protections for consumers who buy drawdown without advice. In the context of DB/DC transfers, such protections may include:
- members in DB schemes having to follow advice of authorised IFAs (the current position is that they have to take advice from an IFA but do not need to follow it)
- quantum out of DB schemes to be limited or available as a percentage – a partial transfer
- greater protections relating to the category of investments or the schemes into which transfers can be made.
The Pensions Industry Group Options for Change paper goes further, suggesting the ability for trustees to refuse a transfer where they have ‘reasonable concerns’ about the validity of the receiving schemes. Such a change may assist where there is valid suspicion of pensions liberation, but it would still not protect against poor decision making, so will not offer meaningful protection where consumers do not appreciate the risks they face or their likely financial needs in retirement.
2017 was clearly eventful in relation to pension freedoms but the extent and impact of DB to DC transfer issues for consumers, trustees and advisers is still not clear.
2018 may provide some real progress with the increased reporting requirements to FCA by September 2018, the Final FCA Report on Retirement Outcome Reviews expected in Q2 2018 and the Work and Pensions Committee final report expected in 2018. These will all shed further light on the extent of DB to DC transfer issues such as examples of poor or no advice and, importantly, what can be done to protect consumers in the future.