What we will cover in this post
In the past decade, huge numbers of people have transferred their final salary/defined benefit pensions to a SIPP or QROPS as Cash Equivalent Transfer Values have soared.
However, since the start of 2022, these valuations have started to fall back and I have had numerous enquiries from people wanting to know why their pension transfer value has dropped.
In this post, we will look at the nuts and bolts of how a defined benefit pension cash transfer value is calculated.
What is a Cash Equivalent Transfer Value (CETV)?
A CETV (also known as a Final Salary Pension Transfer Value) is an amount that is offered to you in exchange for you giving up your entitlement to an inflation adjusted, guaranteed-for-life pension.
It should represent a fair lump sum amount for the benefits being relinquished.
How is a CETV calculated?
Unfortunately, the calculations that are used to value defined benefit pension transfer entitlements differ from scheme to scheme.
As a result, one scheme can offer a transfer value of 12 times the deferred pension value and another scheme can offer 40 times the deferred pension.
To many, the process can seem like a big, black box.
As a help, here are some of the factors that could affect how much you are offered.
1. Interest rates
Anticipated scheme investment returns are linked to interest rates.
These anticipated returns are used to “discount” the value of the transfer offer that is made.
The lower the return, the higher the sum needed to pay the pension and hence the higher the transfer value.
This obviously works in reverse too. The higher the anticipated return (read interest rates), the lower the transfer value.
It is estimated that a rise of just one percentage point in interest rates could see transfer values fall by as much as 25%.
2. Your age
Generally, transfer values rise as you get closer to retirement.
3. Life expectancy
In 1980, life expectancy in the UK was 73. In 2020, it had risen to 81.
For pension schemes, this is a big issue as it means needing to make payments to retirees for an additional 8 years.
4. Cost of living
Final salary pension payments rise each year, based on the cost of living.
The way that these rises are calculated is insanely complex, but the key point is that if inflation is expected to be higher, then transfer values are likely to increase too.
5. Scheme retirement age
Each scheme has a ‘normal retirement age’; usually 60 or 65. All other things being equal, a pension payable at 60 is worth a lot more than a pension payable at 65.
6. Spouses benefit
A pension that pays a large pension to a surviving spouse is more valuable than one that does not.
7. How much your pension provider wants to get rid of you
Some employers and schemes are keen to encourage people to transfer their pensions out because this reduces their risk, in terms of the long-term future cost of paying your pension.
Why are interest rates the biggest threat to your pension transfer value?
Pension schemes have a considerable reliance on government bonds and government bonds produce a yield based on interest rates set by the Bank of England.
According to the Pension Protection Fund’s purple book, pension scheme allocation to government bonds has increased from 28% of assets held in 2006 to 63% in 2019.
As mentioned earlier, interest rates have an inverse relation to the transfer value. I.e. lower yields, higher transfer value and vice versa.
As you can see from this chart, UK interest rates have been virtually zero for more than a decade now.
At the same time, UK defined benefit pension transfer values reached record levels, peaking in November 2021.
This tailwind for pension transfer values is likely to reverse in the near future.
With UK inflation expected to hit 6% this spring, we can expect Bank of England base rates to finally start to increase.
How will rising interest rates affect pension transfer values?
o illustrate how rising interest rates might affect transfer values, imagine that someone wants to receive £1,000 pa in interest.
If interest rates are 0.25%, they would need to have £400,000 in the bank to generate the required amount.
However, if interest rates rise to 0.5%, then they only need to have £200,000.
For the purpose of this illustration, if we make the assumption that this is how pension transfer values are calculated, it shows that the scheme would not need to offer such a high transfer value if interest rates increase.
The Bottom Line
The purpose of this post is to be informative and shed some light on the “black box” that is the pension transfer value calculation process.
It should not be viewed as a recommendation to accept or reject a pension transfer value.
For that, you take personalised financial advice that is based on your unique needs and circumstances.
