Unintended consequences of transfers

Over the last couple of years, some Trustees of UK DB Pension Schemes will have seen a significant uptick in the number of members electing to ‘cash-in’ their proposed pension. This trend was initiated with the introduction of Pensions Freedoms in April 2015. It has since been fuelled by lower interest rates (increasing the value of member benefits) and press scare-mongering - with some headlines causing members to take their money and run rather than rely on the continued success of their scheme’s sponsoring company.

While transfer value activity could be viewed as a positive for a DB pension scheme (as it extinguishes liabilities), it is worth being aware of any unintended consequences. Significant transfer activity may lead to significant changes in the context of the scheme which in turn could lead to a need to consider the investment strategy.

This is illustrated below by an underfunded scheme (60% funded on Technical Provisions with assets of ￡60m) which experiences significant transfer value activity (￡20m). In this example, the level of transfer value activity leads to a significant funding level impact. 

This is for illustration only - for simplicity I am ignoring that the TV basis may well be different to the Technical Provisions basis and I am assuming no reduction is applied to transfers. In reality, more accurate (scheme specific) assumptions here would lessen the impact on funding levels illustrated below.

Appreciating the simplification above, this change to the scheme context will mean

• The required return to meet the funding objectives increasing so the investment strategy may need to become more “on-risk” as a proportion of assets
• The liquidity profile of the scheme will have changed so the amount of illiquid assets previously held may now be higher than appropriate
• With the removal of significant liabilities, the liability hedging arrangements will need to be considered to take account of this (both level and shape)

This shows the continued importance of Integrated Risk Management. Non-investment matters need to be understood to ensure we consider the investment strategy appropriately given unintended consequences.