Employers that want to incentivise staff to move out of a defined benefit pension scheme by offering them an enhanced transfer value deal must be aware of the potential pitfalls, says Nicola Sullivan

As the credit crunch increasingly wipes the value off of pension scheme assets, many employers offering defined benefit (DB) pension plans may be looking for ways to handle rocketing liabilities. One way of managing pension scheme deficits is to offer members an enhanced transfer value (ETV) to incentivise them to leave the scheme. This is particularly suitable for employers that believe the cost of the transfer value in addition to any enhancement is less than the liability or the cost of managing this.

For example, it may cost an employer £200,000 to fund the cost of an individual's pension compared to a transfer value of £150,000. If they successfully encourage that member to take an enhanced transfer value of £180,000, therefore, the organisation will have reduced the cost of the liability by £20,000.

Paul Dooley, senior consultant and actuary at Aon Consulting, says: "From the members' perspective, they are swapping a fairly well-known amount of benefit in exchange for something uncertain, so members are only likely to take that offer if they think there is a good enough chance they will be able to replicate the pension, or ideally create a larger pension, by going their own way. From the employer's point of view, it is reducing its DB liabilities. The risk that it bears providing a DB pension might be worth the cost of enhancing the transfer value."

Employers that want to reduce pension liabilities in this way should be mindful of the Pensions Regulator's guidance on offering inducements and incentives designed to encourage employees to transfer out of a scheme, which was published in 2007. This was intended to advise against employers making unfair offers and poorly communicating arrangements to staff. The guidance stipulates that trustees and employers must give scheme members full and proper information so staff fully understand the implications of transferring out of a DB scheme.

Danny Vassiliades, principal and head of employer consulting at Punter Southall, says it is best practice for employers to offer employees independent financial advice to establish whether or not they are suitable to enter into an ETV arrangement.

"It is not suitable for everybody," he explains. "It depends on age and marital status, their expectations of their life expectancy and their attitude to investment. If they have got loads of savings they might be able to take more of a risk with their pension fund. If their pension fund is all they have got for their retirement, they might be more risk averse. It is a unique decision and that is why a lot of people need financial advice."

Dooley adds: "You might have an ETV exercise where you only target a particular section of membership, rather than a scattergun approach where you offer enhancements to everyone."

Some employers may offer cash inducements to entice members to accept an enhanced transfer value. In its guidance, the regulator calls for all such offers to be scrutinised by trustees because they can complicate an employee's financial decision. For example, Suzi Lowther, head of corporate communication at Hargreaves Lansdown, says such cash payouts could jeopardise members' interests by encouraging them to enter into an ETV, even if they had been advised against doing so.

"A number of independent financial advisory (IFA) firms will not actually advise in enhanced transfer cases when a cash offer is being made," she explains. "Even when a IFA has made the recommendation that it is not in the member's interest to transfer, if they then do want to go ahead, it effectively becomes an insistence transfer."

When communicating ETVs to staff, employers should be frank about their reasons for dealing with their pension liabilities in this way. That said, employers need to be careful not to panic pension scheme members. It is justifiable to highlight alternative cost-cutting measures that would have to be deployed.

When establishing whether a pension scheme member should accept an enhanced value transfer, IFAs will assess the critical yield that is needed for the employee's transfer value to match the pension benefit being sacrificed.

Smart employers will establish the difference between the normal transfer value and the ETV recommended by the IFA and then pick an enhancement somewhere inbetween that will be attractive to the member. This means that the employer can get the highest reduction in liability for the least amount of cash†

†If you read nothing else, read this...

  • Guidance from the Pensions Regulator stipulates that employers must make sure members fully understand the implications of transferring out of a defined benefit pension scheme through an enhanced transfer value (ETV) deal.
  • Cash inducements could jeopardise pension members' interests by encouraging them to enter into an ETV, even if they had been advised against doing so by an independent financial adviser.
  • †Employers should be open about the reasons for wanting their staff to accept an ETV.