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Article | Pensions Briefing

DB transfers: Five questions for scheme sponsors

As DB transfer activity remains high, what does this mean for employers?

Pensions Corporate Consulting|Pensions Risk Solutions|Pension Board and Trustee Consulting

By Stewart Patterson | July 11, 2018

With the level of transfers out of DB pension schemes at an unprecedented high, Stewart Patterson considers five key questions that may be on the minds of corporates sponsoring defined benefit pension schemes.

1. What accounting impact might an increase in transfer activity have?

Accounting impacts will differ across pension schemes depending primarily on the relative strength of the transfer value basis against the accounting basis. It’s not always obvious whether high transfer activity will be beneficial for the accounting position and scheme-specific analysis is usually required to determine the extent to which the transfer value basis is weaker than the accounting basis (both bases are broadly intended to be best estimates, albeit they are usually determined in different ways). If the transfer value basis is weaker than the accounting basis (meaning that the transfer value is lower than the accounting liability value) transfer activity will improve the accounting position.

The accounting standard being adopted and the extent to which transfer activity is already assumed will also play a key role on the accounting impact. Any accounting gain or loss resulting from business-as-usual transfer activity is usually attributed to member experience and will appear gradually through the balance sheet with no impact on the P&L. 

For a bulk transfer exercise, where a group of members are actively contacted with information regarding their option to transfer, the impact is usually more pronounced. Some accounting standards (including IAS 19) require a settlement impact to be disclosed through the P&L and sponsors will want to plan accordingly for this. Whether the settlement impact is positive or negative can depend on the volume of transfers as well as the interaction between the scheme’s transfer basis and the sponsor’s accounting basis; both of which can be influenced by different market factors. If the impact is a settlement charge, this may be off-putting in the short term, but the benefits of a bulk exercise are more obvious when looking longer term; shrinking the absolute size of the pension scheme on the balance sheet, and for most schemes, reducing the future net interest cost flowing through the P&L.

However, sponsors should exercise caution when considering whether to include an assumption for transfers within liability calculations. It will not always produce a favourable result to do so, and as always with pension scheme accounting, year-on-year inconsistencies in assumption setting are likely to be viewed unfavourably by auditors.

2. What de-risking opportunities might an increased level of transfer activity bring?

High transfer activity that leads to liabilities being extinguished will naturally reduce the absolute level of risk inherent within the scheme (primarily investment, inflation and longevity risk).

If the trustee and sponsor are satisfied with the current overall level of risk within the scheme, any release in the risk budget achieved through members transferring could be reallocated to the investment strategy. Even after assets have been disinvested to pay out transfer values to members, it may be possible to further disinvest low-risk assets such as government bonds or part of the liability-driven investments portfolio, and use the proceeds to purchase higher-yielding assets in pursuit of an investment return kicker. This could be constructed in such a way that maintains the overall level of risk within the scheme, ensuring key risk metrics such as the scheme’s value at risk remain broadly unchanged, and leaving the hedge ratios unaffected.

A funding gain will also be realised when members transfer out of the scheme, which could be used to further de-risk the assets and/or liabilities, especially if the trustee would rather bank any risk reduction now rather than see it reallocated as described above. Any funding gain realised could be used to finance the de-risking of the investment strategy to a better-matched portfolio without pushing back the ‘end-game’ target date, or alternatively the funding release could be reinvested to carry out further liability management projects such as a pension increase exchange or the purchase of bulk annuity contracts (buy-ins) for pensioners.

3. There has been lots of media attention around DB transfers, how can we protect our reputation in the event members make poor decisions?

More than ever, DB transfers are in the media spotlight and it is understandable that scheme sponsors might be concerned about the consequences in the event that members of a scheme they are sponsoring make poor decisions. Fortunately there are tried and tested ways to mitigate the risks involved in facilitating and informing members about DB transfers. 

A key cause of members making poor decisions is being ill-informed and receiving financial advice from a less reputable or commission-based financial adviser (where the fee charged is contingent on a member proceeding with the transfer). The best way for sponsors to avoid this is to work collaboratively with the trustee to communicate effectively and partner with a reputable financial adviser having carried out thorough due diligence via a screening process. 

Paying for members to receive financial advice at the point when they are faced with the option to transfer out of the scheme improves member engagement, leading to more members receiving regulated impartial financial advice.

Figure 1. Benefits of a fully-supported financial adviser process, providing paid-for financial advice to members

Chart: Benefits of a fully-supported financial adviser process, providing paid-for financial advice to members

Figure 1 shows that the benefits of paying for financial advice are not limited to reducing the risk of poor advice. From a sponsor’s perspective managing cost is key and it can be demonstrated that the cost of paying for financial advice is quickly reclaimed through funding savings and ongoing administration costs.

4. How do transfers affect the long term funding target of the scheme?

Whether the scheme is aiming for buyout or run-off, members transferring out in large numbers should accelerate the journey plan and bring forward the target date for the scheme’s end-game. This is because for each member transferring, the target buyout or run-off reserve will be significantly higher than the transfer value paid to that member, generating a funding release and improving the funding level. The grey shaded box in Figure 2 illustrates how a high level of transfers, either through business as usual activity or initiated through a bulk exercise, can help to reduce the buyout deficit for an average scheme.

Figure 2. How a transfer exercise might reduce a buyout deficit

Graph: How a transfer exercise might reduce a buyout deficit

5. Should an allowance for transfers be made in the funding valuation assumptions?

For the vast majority of schemes, introducing an assumption for members to transfer out at or before retirement will improve the outcome of the funding valuation, resulting in a smaller deficit and higher funding level than would otherwise have been the case.

Whilst there is not a great deal of experience to inform a transfer-out assumption (three years is not long in the life of a pension scheme!), it would be difficult to argue that the experience observed over the past three years, shown in Figure 3, is anything but compelling. 

Figure 3. Activity in defined benefit to defined contribution transfers for members aged 55 or older from a representative sample of Willis Towers Watson clients

Graph: Activity in defined benefit to defined contribution transfers for members aged 55 or older from a representative sample of Willis Towers Watson clients

As a result, the argument for introducing an assumption for transfers is becoming stronger, especially as there does not seem to be any intention to undo the introduction of ‘pension freedoms’, the key catalyst that has led to the vastly reshaped pension landscape.

Trustees are understandably likely to be wary about introducing such an allowance into funding valuations. After all, they are required to ensure that the scheme is funded prudently and introducing such an allowance would be giving up a significant layer of prudence.

The extent to which scheme sponsors will want to negotiate on transfer assumptions will depend on their specific objectives and the interaction with other assumptions such as commutation. Some sponsors will be happy to continue to fund schemes prudently, in which case the status quo of not allowing for transfers might be where valuation negotiations end up, but for sponsors who are more focused on minimising cash contributions, negotiating on the transfer assumption might prove fruitful.

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