The 'pensions freedom' reforms come into effect on 6 April this year. Members of the Local Government Pension Scheme (LGPS) will be able to transfer their existing benefits into a defined contribution (DC) arrangement to take advantage of the new options.
The regulations around this process are still being finalised, and the DWP is rushing these through without consultation because of the urgency. The Pensions Regulator and the FCA are currently consulting on draft guidelines.
At a high level, the Government is introducing two new safeguards:
> A member considering moving to a DC arrangement must take independent regulated advice if the transfer value is over £30,000.
> An adjustment can be made to the transfer value if there is a requirement to protect the funding of the scheme.
Much has been written about the potential rush of LGPS members looking to transfer out after April, and the effect it may have on the solvency and cash flow of each fund. Some experts suggest that, while transfers out may in the short term present challenges to cash flow, in the longer term they may benefit funding levels by reducing liabilities.
One area that has not received much focus is the impact these changes will have on those in ill health. Currently, an LGPS member in ill health may have access to their pension early (through an ill health ruling) and, when they die, their spouse (if they have one) or dependants will be entitled to a pension.
The pensions freedom reforms change the dynamic of this by highlighting the range of options now available to the member. For members in ill health, it could be worth transferring out of the LGPS, taking their 25% tax-free lump sum and purchasing an impaired life annuity or using the new pensions freedom options. The benefits payable from this type of arrangement could well be significantly more than the LGPS pension given up, especially if the member has no spouse/dependants.
From the LGPS fund's perspective, this could present a significant challenge. A defined benefit (DB) scheme operates by not only pooling investments but also pooling the mortality risk of its members. If those most likely to die early transfer out, it will leave the scheme operating on very different actuarial assumptions from those that were used when establishing its cost basis.
A comparison can be drawn with the UK annuity market when impaired life annuities (also referred to as 'enhanced annuities') were introduced. Their effect was to reduce significantly the returns available for annuitants in good health. For LGPS funds, a move by members in ill health to taking impaired life annuities or using the new pensions freedoms cannot be balanced by reducing the benefits for healthy pensioners. This could impact on the funding levels of LGPS funds and the cost control mechanism.
So what should funds do about this? Well, from a governance perspective, funds may need to track the potential impact that ill health transfers could have on funding. To ensure best outcomes for members, funds could communicate how members who are smokers or are in ill health could potentially receive greater benefits by transferring out of the LGPS. This could include an example of how this would work and recommend that they consult an independent financial adviser (IFA) if they want more details. An IFA will need to consider the options available to the member, including inheritance and tax considerations.
Finding the balance between ensuring the best outcome for an individual member and the overall health of the fund will become increasingly challenging!