February 13, 2009 4:37 pm

Rise in transfer values out of final salary schemes

Quirks in accounting rules have increased the value of final salary pension transfers, even though many schemes are significantly underfunded.

Financial advisers say the value of transferring out of some final salary schemes has risen by as much as 85 per cent in the past few months.

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At first, it may seem puzzling that scheme members are being told that the cash value of their pension has risen, at a time when funding for the schemes is so poor.

After 18 months of falling stock markets, the funds accumulated to pay out annual pensions to members of final salary schemes are now in deficit to the tune of around £200bn.

In an attempt to manage these shortfalls, employers have been closing schemes to new members. Hundreds of thousands of employees are set to lose their right to a final salary pension over the next few years, according to the National Association of Pension Funds.

So, underfunded schemes should have lower transfer values, in order to protect the pot of money needed to pay out pensions to existing members. But in October last year, the Department for Work and Pensions set up new rules to determine the value of an individual’s final salary pension. The changes mean that if a employer is still solvent, transfer values should not be reduced, even if the scheme is underfunded.

At the same time, gilt yields, which are used to determine the rate of return on pension investments, have fallen. So, as the assumed rate of investment return for final salary schemes fell at the end of last year, the amount quoted for transfer values rose.

This is because transfer values use the assumed rate of annual return to calculate the amount of capital that savers need to attain the same annual pension they get in a final salary scheme. If returns are low, the amount of capital needed for investment needs to be greater.

It is too early to say if the increase in transfer values will last. Trustees who want to lower transfer values because of underfunding can still do so – as long as they commission a special report detailing the reasons for the change. If more of these are commissioned, then transfer values could start to fall quickly.

Keith Williams, actuary at First Actuarial, points out that gilt yields are also starting to rise, meaning the assumed rate of interest will rise and values could fall.

Investors who want to control their own pension, or are concerned about the funding of their scheme and whether the UK’s protection scheme will cover their retirement benefits, are therefore being advised to request an updated version of their transfer values now.

In spite of the higher transfer values for most people, the benefits of a final salary scheme – which pays out an annual proportion of salary regardless of how well or badly the underlying investments are performing – will usually outweigh the benefits of transferring out.

Those who opt out and invest the money themselves, without the protection of the scheme, may find it difficult to achieve returns that match their scheme’s assumption, warn advisers.

“An increased transfer value does not necessarily mean investors are advised to transfer,” says Laith Khalaf, pensions analyst at Hargreaves Lansdown.

“Final salary benefits are often so good that even a substantial rise in the transfer value may not change the recommendation not to transfer.”

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