The Transfer Value Comparator explained
- Author : Novia Financial
- Date : 16 Nov 2018
‘Savers 10 years away from retirement could lose nearly half of the value of their defined benefit pension if they choose to transfer.’ That was the headline when the Transfer Value Comparator (TVC) was introduced by the FCA in October. Advisers now face the challenge of folding the TVC into their advice process in balance with its predecessor, the Critical Yield.
With the average transfer value being only 55%1 of the estimated replacement cost of the pension, a graph looking like the above will not be uncommon.
So what’s the real purpose of this comparison? Going back to the FCA’s policy statement:
The purpose of the TVC is to provide consumers with some context for the level of their transfer value to help them make an informed decision. That context is the cost of providing the same benefits as the DB scheme but in a DC scheme. 2
As most advisers would agree, nobody transfers from a DB scheme in order to buy back exactly the same benefits in a DC scheme. That would be like pawning your watch and then taking the money to a different shop and buying an identical watch. So why is the comparison done on this basis?
The FCA considered this in their consultation. An annuity is still the best match for a comparison to a DB pension. The critical yield, which the TVC has effectively replaced as the starting point for analysis, was also based on the cost of an annuity.
…the notional annuity purchase is being used as a proxy to determine the value that might be gained or lost by giving up the safeguarded benefits. We consider that this will be easier for consumers to understand than the critical yield concept and will help frame their decision. 3
So the TVC is evolution, not revolution. However, one key element differs considerably: critical yield was based on the actual charges that apply in the receiving scheme, whereas the TVC is based on prescribed assumptions. Because it’s not personalised, the TVC doesn’t meet the requirements for a personal recommendation – yet it’s the only mandatory element of Appropriate Pension Transfer Analysis, in which a personal recommendation is mandatory. In any case, the client needs to see the TVC, so it will provide a starting point for a conversation. Given the challenges of contextualising the graph, it’s no surprise that many advisers will want to start that conversation with an explanation of how the second column is calculated.
It might help to imagine a third column to the right of the second which exists in the calculation but not in the graph itself. The third column would show the estimated cost of buying the annuity at normal retirement age. This is calculated with reference to the usual Annuity Interest Rate assumptions – no different to the old critical yield calculation really, except for a minor adjustment to the rolling Gilt Yield average (to sharpen it up a little to market movements). However, in the case of the TVC, the cost of the annuity is loaded with an additional 4% which is designed to simulate the cost of advice.
The 4% annuity charge is intended to cover both the product and advice costs of buying an annuity. Firms have previously told us that 4% is an appropriate figure. 2
So, the (invisible) third column is the estimated replacement cost of the pension, plus 4%.
The second column is the third column discounted back to the present day. This is so that the annuity purchase cost is represented ‘using today’s costs’.
In the prescribed notes section of the TVC:
2. The estimated replacement value takes into account the returns that you could receive and any charges you might be expected to pay.
One could be forgiven for thinking that this means the TVC uses real rates of return and real charges to discount back to present day. However, in order to prevent advisers from ‘gaming’ the results with unrealistic investment scenarios, the growth rate has been suppressed to a ‘risk-free return using gilt yields’ and the charges reducing that growth have been fixed with a mandatory assumption of 0.75%.
Rolling all this into the calculation, the resulting discount rate could be considered very conservative. Much like the child of tall parents, the second column doesn’t stand much of a chance of turning out dainty. With a 4% expense loading and a discount rate that is almost halved by charges, the second column can easily loom over the first. The further from retirement the client is, the bigger the size difference is likely to be. Also, the critical yield is likely to be smaller when the client is a long way from retirement – so the longer the time horizon, the bigger the likely disparity between the TVC and the critical yield. For illustrative purposes only:
Whether or not the TVC is realistic, it is at least consistent. Or is it? There are different ways to implement the COBS requirements. The term of gilts used in the ‘risk-free return’ needs to be ‘appropriate’. There are many ways to interpret this. Whilst differences in implementation across different analysis tools may be small, any differences will be magnified by longer terms to retirement.
1 Analysis from Royal London and Lane Clark & Peacock.
2 FCA PS18-06
3 FCA CP17-16
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