When I started my investment career in the mid-1980s, the path to financial security for employees of large companies was relatively straightforward. There was ‘upwards only’ salary progression, and you received a guaranteed pension from the company’s Defined Benefit pension scheme when you retired.
Today, the outlook for financial security from Defined Benefit (DB) pensions schemes has altered and deteriorated significantly with the pandemic having a further negative effect.
While DB pension schemes use equity and other assets that should protect against inflation over the long term to help build up their values, the guaranteed incomes (pensions) promised to their members depend on bonds and bond yields. The very low bond yields of recent years mean that bonds are more expensive, and hence so too are the costs of the promised pension benefits. So, pension fund liabilities, effectively all those pension promises, have become more expensive as bond yields have fallen.
Quantitative Easing was introduced in the wake of the 2007 – 2008 financial crisis to stabilise the financial systems and bail out banks. Central banks around the world injected massive amounts of money into the economy by buying up bonds from financial institutions, in the expectation the sellers would use the money to lend to businesses and households or to invest. This huge buying of bonds drove prices up and yields down. In particular, the yields on high quality European corporate bonds have contracted significantly, as you can see in the graph below. As AAA and AA corporate bond yields are the core valuation benchmark for pension schemes, this has put substantial upward pressure on pension fund liabilities.
Better life expectancies and longer-term pension payments have also contributed to higher liabilities over the past two decades. Falling bond yields plus increasing longevity is a very negative combination for anyone trying to manage and run a Defined Benefit pension scheme. DB funds have been in deficit since the early days of the financial crisis in 2008, despite the huge bull market in equities over most of this period.
It’s no wonder the sponsoring companies of these DB schemes are becoming increasingly frustrated and looking to exit from their ever more onerous pension responsibilities. To try to retain the viability of their schemes, companies are increasingly looking to implement actions to alleviate the financial strains on the schemes such as:
- Seeking additional contributions from the sponsoring company
- Seeking additional contributions from members
- Reducing retirement benefits
- Raising the retirement age
- Reducing indexation of pensions
No prizes for noting that bar the first one, all the above items negatively affect members and reduce their pension benefits and/or financial security.
The pandemic has exacerbated these concerns. The additional monetary stimuli has caused bond yields to fall further (increasing liabilities further). Many companies were forced to cut their dividends due to sudden adverse cashflows because of lockdowns. For pension funds with investments in these companies, they lost the dividend flows and possibly saw market value decreases. In the UK for example, about 40% of companies in the UK equity market cancelled, cut or suspended dividends. Within Europe, all quoted banks had to suspend dividend payments. Not only that, but for those companies that had to cut their dividends, their ability to continue funding their pension liabilities was also squeezed. According to the UK Pensions Regulator, some 10% of UK DB scheme sponsors have agreed a suspension of deficit contributions with scheme trustees, weakening the financial strength of these schemes. In more extreme cases, companies have gone into liquidation.
It all sounds gloomy for DB scheme members and their financial security, but there is a silver lining. While QE and lower bond yields have led to an increase in pension liabilities, they have also led to an increase in pension transfer values. And with companies getting increasingly frustrated that despite strong equity markets and increased company contributions, the financial positions of company DB pension schemes don’t seem to be getting better, they are almost encouraging members to leave and take their liabilities with them via the transfer values. Remember that once a DB scheme member retires, his/her pension rights become stronger under current legislation so there is an incentive for companies to encourage active members to take transfer values before retirement.
Transfers into Pension Retirement Bonds (PRBs) or PRSAs can open up a number of financial options not available from a DB pension. Each person is different, and individual transfer value calculations can differ significantly between DB pension schemes. It is extremely important that anyone considering taking a transfer value gets expert advice (legal requirement in the UK for transfer values above £50,000) on both the transfer value and the options going forward. This is an area in which Cantor Fitzgerald has much experience and expertise.
Here is an example of a real live transfer value case we came across recently (names and amount changed to protect client confidentiality, but ratios are similar):
Niamh worked for almost 20 years for a leading multinational company (Global Inc.). She left the company in 2012 and took up another employment, at which she still works. When she left Global Inc., she left behind a deferred pension entitlement of €19,000 a year payable from age 62.
Now that Niamh has reached this age, Global Inc. made contact about her pension options. As well as her deferred pension entitlement of €19,000 p.a., the company DB pension plan offered her a transfer value of €590,000.
Niamh asked her adviser for assistance, who in turn approached us. Based on financial circumstances, the deferred pension entitlement of €19,000 (gross) would not really change the day-to-day lifestyle of Niamh’s family. We were able to advise her that the transfer value was an attractive option to seriously consider based on her own personal circumstance with identified needs and objectives.
By taking a transfer value into a Pension Retirement Bond (PRB), Niamh could access a number of financial options that could significantly improve her family’s financial security:
- Funds can remain in the PRB up to age 70
- Potential of tax free lump sum on retirement of the PRB
- Approved Retirement Fund (ARF) on retirement of the PRB
- Whatever is left in the PRB or ARF after her death passes onto her estate
- Flexibility to purchase an annuity later if annuity rates become more favourable (bond yields go up)
- Access to emergency funds from the ARF, albeit subject to tax, for example in the case of a family medical emergency
Obviously there are risks involved in taking this transfer value option:
- investment risk as the value of the investments may fall as well as rise
- the need to manage the PRB and ARF
- longevity risk if she and her husband live to age 90+, have high expenditure and have relatively poor investment returns.
These are risks that must be properly discussed with Niamh and her adviser, and she has asked us to develop an investment strategy that is lower risk but also has flexibility to generate a low to medium single digit return over the longer term.
The financial flexibility and options outlined above would significantly increase the financial security of Niamh and her family, particularly access to a tax efficient lump sum that could be used to assist her (grown up) children to purchase houses in the coming years.
The example above is admittedly a particularly attractive transfer value case, but with the improved transfer value options in general because of low bond yields and companies’ objective of removing pension liabilities, we are seeing more and more cases where the transfer value option is attractive and could improve the financial security and optionality of individuals. A silver lining from this Coronavirus crisis!
Pramit Ghose is Global Strategist with Cantor Fitzgerald Ireland.
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