Revolution in the defined contribution (DC) world will happen on 6 April 2015. Tightly restricted options will be replaced by freedom and flexibility. DC members seem excited by the prospect. Will defined benefit (DB) members want a piece of the action? What will really happen? Will there be a stampede or a trickle of DB members transferring out to the new DC world? Are trustees of DB schemes ready?
We are seeing DB scheme trustees considering a number of member options. As well as the communication challenges, some DB trustees and employers are looking at how the new DC flexibilities might help their funding positions but also present new challenges.
A flood of transfers out!
For years the transfer activity from DB schemes has been extremely low. Many schemes in deficit do not have an insufficiency report which would allow reduced transfers and some have not reviewed the factors for a long time. When hardly anyone transfers out - what's the point?
Now we face the possibility of increased transfer activity. With some members hungry to access their pensions for more flexible options, trustees need to make sure they are balancing the interests of those keen to transfer out against the security of those who want to stay. This is why a proper review of factors and a debate on reducing transfers is now necessary.
The statutory right to transfer ends 12 months before normal pension date. Some schemes are changing their rules to allow discretionary transfers in this period until the law is changed to extend these statutory rights.
The views of employers are also relevant. Some employers may not wish to see transfers reduced, fearing this could discourage transfers. But a scheme heavily in deficit may not be able to risk the funding strain of a large number of unreduced transfers without extra employer contributions to underpin member security. This is a debate which needs to be had now.
Best of both worlds - the partial transfer
Some trustees and employers are thinking more deeply about the transfers question. Maybe expecting members to transfer all of their DB benefits out is too big a step? What if members could transfer some of the benefits while leaving a core DB promise as guaranteed income in retirement? This approach would reduce the scheme's liabilities but also help protect members.
It's true that this idea is not yet "all the rage" but it has some potential. The key difficulty is that contracted-out schemes face legal challenges in carving up contracted-out benefits to make a partial transfer option attractive to the scheme and the member. How do you make sure you end up with liabilities which are big enough to justify the effort of administering them and which are also attractive to buy-out one day in the insurance market?
There is not yet a statutory right to a partial transfer which would allow slices of contracted-out benefits to be paid. Such partial transfers require a special rule amendment and should be discretionary. This means that conditions to the transfer can be applied, creating an environment in which partial transfers can be mutually beneficial. But the process and conditions must be carefully considered in order to avoid the exercise of discretion to create real legal issues in the future if members regret the choices made and seek to reverse them.
Getting rid of the tiddlers - small pots and trivial commutation
Now the tax limits for commuting small pots and trivial benefits are much higher, some schemes are looking at the level of liabilities covered by these benefits. We have not seen trustees forcing members to cash in their small benefits, but there is interest in reminding members of their options.
Trustees must ensure they have the power to cash out small benefits as the relevant legislation is not overriding. Actuarial factors need to be looked at to make sure they are fair.
An additional complication is whether the Incentives Exercises for Pensions Code of Practice applies. The communication requirements of the Code are helpful but is there a need to pay for IFA advice? Recent announcements suggest that the Code does apply unless the exercise is "business as usual". Uncertainty on what this means has deterred some trustees, but in most cases, as all the trustees want to do it remind members that they have this option, the Code should not apply.
What to say to members?
There is currently much hand wringing on what members should be told in the run up to April and beyond.
Is it ok to add a transfer illustration or commutation illustration to a retirement pack or should the packs simply refer to these options? Should trustees send out benefit statements with reminders of all of the options or go further and provide illustrations?
There is a tension between trustees running their schemes in accordance with their rules and providing the benefits promised and the obligation to provide information on member options. There is also a temptation to say either too much or too little - getting the balance right could be tricky.
Whatever information the trustees do decide send to members, it is crucial to stick to factual and balanced messages which are designed to only inform members of the options and not to tempt them to either retain or desert their defined benefit promise.
Case law suggests that badly or ill-conceived member communications always run the risk of creating unexpected legal complications and care should be taken on exactly what members are told and how.
What are the practical implications?
Some trustees have been so focussed on the funding and communication issues that they have not paid much attention to the administration, cash flow and investment issues. While DB members transferring or cashing in benefits should have a positive impact on funding levels in most cases, being able to properly administer and pay such benefits is crucial. Once the cash is in sight, members will not want to wait long periods for the payments to be made.
On the investment front, if the nature and duration of the DB scheme's liabilities start to change, carefully thought out investment strategies to match future expected cash flows could begin to unravel. This is also something to watch out for and keep under review.