Making correct call on pensions is critical

If you are lucky enough to be a member of one of the country's few remaining final salary pension schemes, you may have been made an offer to give up some of your "gold-plated" benefits.

In recent years, growing numbers of the country’s biggest private-sector employers have approached their workforces with deals to buy out inflation proofing on their future pensions, in exchange for a bigger starting, but flat, income.

In 2012, in the UK, 70,000 defined-benefit (DB) members were offered these deals, known as Pension Increase Exchanges or "pies", a big jump on the year before, according to KPMG.

And appetite continues to grow. Over the next year, about 150,000 pensioners in the BT group scheme will be offered more income today in exchange for surrendering their inflation-proofing.

The benefits for employers struggling with pension deficits are obvious. Swapping an uncertain cost in the form of index-linked rises for a certain cost, in the form of a book of level pensions, is highly appealing. But the financial case is far less clear cut for members of such schemes.

The British pension regulator’s advice is that these offers “will not be in most members’ interests”.

Cash uplift
Inflation-proofing is a prized benefit of final-salary pensions. Guaranteed year-on-year rises, typically linked to the UK's retail prices index (capped at 5 per cent) or consumer prices index, provide rare peace of mind for members in an uncertain economic environment.

But working out whether a cash uplift is fair value for what’s being surrendered is notoriously difficult. For the individual, it means taking a punt on how long they will live and what inflation will be in 20, 30 or even 40 years.

Big corporate pension departments have access to actuaries, economists and statisticians to help them crunch the numbers. Members have no such resources at their disposal.

This information asymmetry is critical, as pensions are complex and the consequences of making the wrong call are likely to be far more profound for individuals and their beneficiaries than for a conglomerate. Once an offer is accepted, that decision is irrevocable.

If inflation is higher than anticipated, or the member lives beyond the average 20-25 years post-retirement, their pension will diminish rapidly. The impact will also be felt by a surviving spouse who inherits the “frozen” pension.

Minimum standards
Is there any regulation of such momentous decisions? Well, sort of, in the UK at least. A new Code of Good Practice sets minimum standards for the way offers are presented to members. But the code is voluntary and relies heavily on what is called a "balanced deal test". Essentially, this weighs up the value of the pension uplift compared with the value of the pension increases given up.

While a percentage of 100 may give an air of comfort to the member, there are important shortcomings about this value that need to be highlighted.

First, the code does not require each member to get a “balanced deal” for the offer to achieve a 100 per cent rating. It only requires that offers which leave “some” members materially below 100 per cent and others materially above “should be avoided”.

What this means in plain English is that there can be “losers” in the mix but the spread between winners and losers shouldn’t be too great. As the value calculation is also on an aggregate basis, individual losers remain unidentified.

The consequences of this discretion are significant for members. British employers whose offers have passed the balanced deal test, even with potential losers aboard, can offer a less rigorous (and less costly) “guidance” process to members who want help deciding.

This contrasts with more rigorous “full blown” advice that must be offered on deals that have fallen below the test.

But because of a regulatory quirk, any advice given is not regulated, meaning no comeback for poor advice.

These loopholes have the potential to let down members. There are limited cases where individuals may benefit from giving up inflation proofing. But they are at risk of walking through the process with their eyes half open. Members have the option to refuse offers or pay for “full advice”. If you’re offered a “pie”, don’t just take it – seek advice. – Copyright The Financial Times Limited 2013