How final salary transfers are calculated: unraveling the mystery of the overnight millionaires

Low interest rates have created a bonanza of high final salary pension scheme transfer values in the last couple of years. Thousands of members have taken advantage by transferring out of their schemes. This has made them considerably cash richer and even mysteriously seemed to turn many people on average professional salaries into millionaires overnight.

My clients often ask me how final salary schemes calculate values to arrive at such high figures; and how much longer these handsome sums are likely to be available?
Actually, interest rates are just one of many factors that schemes consider when setting transfer values. But they are a major factor currently and if rates keep rising, transfer values could start falling soon.

Future investment returns

The technical term for the amount you can take from a final salary scheme is a cash equivalent transfer value (CETV) and represents what the scheme administrators are prepared to pay out as the cash value of the benefits you are surrendering. However that could be greater or lower than the actual equivalent benefits you would receive should you choose to buy the same pension in the open market.

In calculating the value, schemes will normally consult actuaries as to how much the scheme’s benefits might cost in future. The calculation will use a whole list of assumptions including future inflation rates, life expectancies and investment growth.

The investment growth assumption translates into what schemes call the ‘discount rate’, which is the amount of money the scheme needs today to meet future benefits after discounting growth. This is what they use to calculate the CETV, expressed as a multiple of the projected annual income you would have received from the scheme.

The investment return assumption and discount rate are based on long-dated UK government bond (‘gilt’) yields, which are linked to interest rates. Due to the low interest rates of recent years – set by the Bank of England to help the economy recover from the financial crisis of 2008 – gilt yields have been at historic lows, resulting in low discount rates and therefore high transfer values.

To put this in context, a typical scheme today would link its future benefits to an assumed inflation rate of 2.5%, based on long-term trends. But long-dated gilts are currently only yielding 1.45%. So the amount such a scheme needs today to meet future benefits will keep growing, all other things being equal, until the gap narrows between those two figures. Its transfer values will also therefore keep growing.

Liability matching

Most final salary schemes have been closing to new members. As they have done this, they have matched their investments to their liabilities by shifting from volatile shares into bonds, which have more stable and predictable returns. However, as bonds tend to underperform shares over the long term, this has reduced the schemes’ expected growth rates, thus boosting transfer values.

Scheme funding

Another major trend supporting recent growth in transfer values is the desire in many companies to reduce the uncertain impact of potential future pension liabilities on their balance sheets. They have therefore increased values to encourage transfers out, thus offloading their liabilities. Poorly funded schemes might also do the opposite and reduce transfer values, to avoid disadvantaging members left in the scheme. However, the former effect of raising values has been much more common.

Life expectancy

According to the Office for National Statistics, a man retiring at 65 in the UK has an average of 18.5 years of life remaining, compared to 14.5 two decades ago. A woman of the same age can expect to live another 20.9 years, up from 18 two decades ago.

This is another, longer-term reason for schemes having to put aside more money to meet their pension promises, thereby boosting transfer values.

Given that some transfer values have grown to 30, 40, and sometimes more than 50 times income, we can see why many people have seen them as good value compared to the 20 or so years of income they are likely to receive in the scheme.

Scheme rules and benefits

Some clients ask why one person they know in a similar situation has been offered a high transfer value of say 40 times, but they have only received a more moderate offer of say 25 times. The answer is that schemes have different ways of calculating values, and different rules which affect the calculation.

For example, many final salary schemes link their benefits to price inflation. But a pension linked to the retail prices index is more valuable than one linked to the consumer price index because the former is typically 1% higher than the latter. Its transfer values will also therefore be more elevated.

Similarly, pensions that pay larger survivor’s benefits are more valuable compared to ones that do not. And if the scheme has a normal retirement age of 60 rather than 65, the transfer value will also again be higher to reflect the extra five years of benefits.

How long will high transfer values last?

This is difficult to answer with complete certainty due to the wide range of factors at play. But last month, the Bank of England increased interest rates for the first time in a decade – from 0.25% to 0.5%. With UK inflation continuing to climb to a near six-year high of 3.1% in November, boosted by the post-Brexit fall in sterling, the Bank looks likely to keep hiking rates in 2018. This would boost gilt yields, slowing the rate of growth in transfer values and eventually reducing it, as explained above.

Get expert advice

Final Salary Transferwise is a part of independent adviser Blackstone Moregate, which has provided specialist pension planning for 17 years. The team has a combined experience of 70 years.

We assess whether a transfer is right for you by holistically reviewing of all your financial affairs, including goals, assets, income, background, and risk appetite.

Our specialist tools and technical skills also help calculate whether your retirement income will last your entire life and your money will never run out. The result is a fully-informed, professional and transparent recommendation.

With investment specialists in our team, we also make sure the new investments are right for you and explain them carefully.

Transfer value offers typically only stay open for three months. So if you have a good offer, the time to seek advice on it is now.

To find out more:
Contact Richard Hopkins at 020 3376 1444,

Richard Hopkins

Richard is a founding director of Final Salary Transferwise, an initiative of Blackstone Moregate with considerable experience in financial services. Richard provides a holistic, professional and highly personalised service to help ensure his clients meet their financial objectives.

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