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Pension freedoms: transfers from DB to DC schemes

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In this article, Suzanne Padmore, Legal Director at Burges Salmon considers current issues relating to pension transfers and the use of the pension freedom reforms. She also looks 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.

Transfers from DB to DC schemes

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:

  1. 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’).
  2. 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).

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.

The future

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.