In the sections below we have tried to provide some useful background information on a number of topics that may well be relevant to you and your client. If you would like to discuss any of these topics further, please let me know.
This is a very complex question, and it is one where the Financial Conduct Authority requires the assumed answer to be “no” unless properly justified. The advice itself must be provided by a suitably-qualified pension transfer specialist, which typically means holders of the AF3 or AF7 qualifications with the Chartered Insurance Institute or the equivalent from another awarding body.
It is important to consider the client’s circumstances and objectives very carefully when deciding whether a pension transfer was in their interest or not. A recommendation to transfer should be accompanied by a cash flow forecast with a stress-test of the transferred portfolio and a comparison between the retained pension and a transferred balance to a point long after life expectancy (typically I use age 100 for any client under 90, as this comfortably exceeds the expected life remaining, but if both parents lived to 110, it may be appropriate to extend this further).
Cases involving pension transfers are the most complex that it is possible to advise on from a regulatory perspective, so it is impossible to have hard and fast rules on whether a case was correctly advised.
This type of scheme is one where the employer takes on the responsibility for the financial security of the fund that underpins the income. From a member’s perspective, the income is guaranteed and they do not need to consider investment performance. If the sponsoring employer is unable to meet their obligations, the Pension Protection Fund (PPF) may step in to continue to provide income benefits, albeit on a reduced basis.
From a tax perspective, actual contributions into these types of arrangement are largely irrelevant, with the annual allowance impact worked out by the increase in guaranteed pension at the point of retirement. This can be a complex calculation, but generally it means that the real (i.e. post-inflation) increase in entitlement is multiplied by 16. The actual amount paid in to the pension is based on actuarial calculations which account for the current value of the scheme and the required discounted value of the various guarantees that have been promised to members.
Most modern pensions fall into the category of defined contribution. This is where the ultimate outcome depends on how much is paid in, where it is invested and then what type of income generation is selected at retirement. Contributions are generally made as cash and tested against the annual allowance for the individual at the level of the contribution.
For personal contributions, tax relief is usually available at the basic rate of income tax, with any remaining tax relief reclaimable through self-assessment. Importantly, tax relief is not withdrawn simply because the contribution exceeds earned income for the year, meaning it is still possible for a non-taxpayer to reclaim basic rate tax, even if it was never actually paid. Personal contributions can only be made tax efficiently up to the earned income for the year – excess contributions then attract an annual allowance charge.
Contributions made by an employer are, if the contribution passes the “wholly and exclusively” test, relievable against corporation tax and employer national insurance. Such contributions are not limited by relevant earning in the same way as personal contributions, but are still tested against the annual allowance.
When investing, it is near-impossible to predict what sectors and geographic regions will provide the best return for a given level of risk. As such, a common principle of investing is to diversify, or to hold a wide variety of assets from around the world. Blending assets together like this almost guarantees holding both winners and losers, with the overall performance blended to mitigate the worst performing assets. Good diversification means that, for example, failures like Northern Rock do not have a crippling impact on a portfolio as a whole, thought the wider impact of the credit crunch as a whole would still have been felt by most investors, albeit an impact that would have been reversed for a diversified portfolio in the growth years that followed.
Diversification can refer to either single assets or entire sectors. For example, continuing the example above, a portfolio investing in global equities would likely be more diversified than one focusing only on the UK, which in turn would be more diversified than one focused on UK financial institutions. In particular, there were a number of clients advised to hold very concentrated investments in life settlement funds, private equity or overseas property in the past two decades or so.
Risk is a word often used but rarely fixed in terms of definition. At its heart, investment risk is the chance that an investment will lose money compared to either cash or a benchmark. This is often treated as identical to volatility, but this has significant shortcomings, not least of which is the fact that volatility in isolation includes periods of high growth as well as losses.
It is perhaps better to think of risk as uncertainty, in which case there are a few subdivisions to consider, including:
- Inflation risk – the chance of an investment or holding failing to keep up with price rises.
- Market (systemic) risk – entire markets can fall in value at once, either as a result of one of the other risks in this list (e.g. the Russian market as a result of the 2022 invasion of Ukraine) or by simply falling out of favour (e.g. Japanese equities at various times over the past few decades).
- Credit risk – the chance associated with an individual, company or government defaulting on their loan obligations. Most obviously this would have a direct effect on the holders of that debt, but indirectly might affect more investors in the wider market.
- Mortality/morbidity risk – if a key individual for the investment falls ill or dies, the business may well fail. In specific cases such as life settlements funds, this risk may also extend to the cohort of business investments, so the risk may actually be that people live too long rather than dying early.
- Individual holding (non-systemic) risk – an individual investment entity can either be mismanaged or could just fail regardless. This can even happen to very large companies, e.g. Enron.
- Political risk – the actions of governments can have significant impact on investments, for example wars. In addition, sovereign governments tend to reserve the power to affect their monetary and fiscal policies through the setting of central interest rates and the tax codes which apply to investors and employees.
In general, the goal of sensible investing should be to minimise as many of these risks as possible through an appropriate level of diversification. In addition to the above, it is worth considering risk in two distinct categories:
- Capital risk – arguably this is closely linked to volatility measures, as it refers to the price that could be achieved by selling the investment.
- Income risk – if an investor is reliant on their income but has no reason to spend capital (e.g. retirement funding) then it is much more important for them to look at security of income than preservation of capital value.
When it comes to risk, this is specifically divided into three categories by the Financial Conduct Authority:
- Risk tolerance – how much risk an investor is willing to experience.
- Capacity for loss – a mathematical expression of how much risk an investor can afford to take, usually calculated using some form of cash flow forecasting. This category also accounts for the need to take some form of investment risk to achieve their goals.
- Knowledge and experience – investors with significant knowledge and experience may have sufficient education on investments to deviate from the normal risk profiling exercise.
In general, it is important to note that an investment is not unsuitable simply because it performs badly. Investments by their very nature carry with them an element of risk, which means they may well fall in value or fail altogether. This means that just because an investment has fallen in value does not mean that there was any deficiency in the advice given, as the specific outcome of an investment cannot be known in advance. There are some reasons why an investment may not have been suitable for a client, namely:
- Mismatched risk exposure – if the investment was riskier than the client was prepared to take, then the advice can be considered unsuitable even if the investment has actually performed well. In that case, the remedy would be to switch into a more appropriate investment now, taking the additional gain as effectively a bonus.
- Insufficient information – if the investment was not fully explained to the client, they cannot have made an informed decision to proceed. This usually means that the client was unaware of the charges or the underlying investment strategy. It may be that the adviser was themselves unaware, but their duty of care to the client means that they should only advise on assets they have fully investigated.
- Incorrect permissions – if the adviser was not authorised to intermediate on the specific assets in question, then their advice was unsuitable.
- Non-mainstream investments marketed inappropriately. Some investments are subject to additional restrictions over their marketing and advice, usually requiring a client to be either deemed sophisticated or high net worth. If the investment required such a categorisation but the client was not recorded as such, the advice may well be unsuitable.
As a starting point, most tax planning should be done by a qualified accountant rather than a financial adviser. That said, there are some areas of tax planning where it is appropriate for a financial adviser to provide advice, including:
- Structuring investments tax efficiently. This means using the savings allowance and starting rate band (if available) for interest, the dividend allowance for dividends and the annual capital gains tax allowance for capital gains, as well as making good use of the annual ISA allowance where possible. It may also be appropriate to use an insurance-based investment to defer tax to a later year, often referred to simply as onshore or offshore bonds.
- Pension funding, including calculation of maximum contributions both from a personal perspective and for employer contributions.
- Pension crystallisation, specifically with regard to the lifetime allowance.
- Inheritance tax planning methods, specifically including calculation of available gifting and allowances, use of exempt investments (usually under business relief) and the use of insurance policies written in trust where necessary.
- Investment-based tax planning using Venture Capital Trust (VCT), Enterprise Investment Scheme (EIS), Seed Enterprise Investment Scheme (SEIS) or other income tax mitigating allowances.
Advisers should generally not be involved in wider tax planning, including drafting of wills, effecting instruments of variation or the establishment of family investment companies or trusts. Instead a professional should be consulted for these areas.
Prior to 2013, advisers were paid through a combination of commission for arranging investments, pensions or insurance, or alternatively they could take a fee for providing their advice.
Since 2013, commission on pensions and investments has been banned, so all fees should now be disclosed as a charge for services rendered rather than differing based on the product(s) set up. The exception to this rule is where the firm is vertically integrated, meaning it advises on products that it manages itself. In such cases, firms still seem to be able to pay advisers from the product’s charges in a way that resembles commission.
Disclosure rules mean that clients should be made fully aware what fees they are paying and to whom. For firms which are not vertically integrated, this usually means that the client should be told about the product-level charges (e.g. platform costs, trading costs), investment management charges, including underlying costs of the holdings, and advice charges. In essence any charges that arise as a result of the advice should be disclosed to allow the client to make a fully informed decision.
Essentially this boils down to when a decision is made to limit the products offered to clients. For an independent service, the decision is made after the adviser meets the client, essentially excluding products and services that don’t meet the client’s requirements and selecting solutions that remain from the whole retail market. With a restricted firm, this decision is made before the adviser meets the client, excluding one or more products or services from being used with any clients.
In the most restrictive form, a firm may be limited to only distributing the products offered by their company. This is often termed “vertical integration”, and it can ultimately look a lot like pre-Retail Distribution Review distribution channels, including remuneration structures that bear an uncanny resemblance to commission, which is generally banned on investments and pensions.
Importantly, all advice is subject to the same regulations and requirements. As such, regardless of whether an adviser is restricted or independent, they must first carry out a fact-finding exercise, identify goals, assess the client’s risk profile, then advise on a suitable solution given everything they have learned.