Updated 23 April 2020
The number of advisers willing to transfer final salary pensions is falling, due to the perceived risks. Meanwhile, the popularity of equity release is snowballing. But are Brits aware of the risks involved there too? Article by Nick Green.
The number of financial advisers willing to act on transferring out of final salary pensions is in decline, according to the Personal Finance Society, meaning fewer people are able to access this option. However, the market for later-life financial planning is expanding rapidly in another key area: equity release. Increasingly, domestic property is being seen as a rival to pensions when it comes to funding retirement – despite the significant risks that this route involves.
The main reason for the advice shortfall is that final salary pension transfer means tackling big risks. The law states that anyone transferring a defined benefit (i.e. final salary) pension with a CETV of £30,000 or more must take professional advice first. But a financial adviser who approves such a transfer may be held responsible in years to come if the advice turns out not to have been beneficial. Anxious to avoid a possible mis-selling scandal further down the line, some advisers are simply refusing such work.
The FCA said, ‘The decision to give up guaranteed benefits and transfer out of a defined benefit pension scheme is one of the most significant financial decisions anyone can make and can have life-changing implications.’ According to actuaries Mercer, some 390,000 final salary pensions totalling £80 billion have been transferred since 2015, when it first became possible to do so.
Transferring out of a defined benefit pension means swapping a guaranteed lifetime income for a limited pot of money. This pot is then exposed to the fluctuations of the stock market, adding an additional layer of risk. It’s true that if the stock market performs well, the pension holder can potentially be better off financially than they would have been in the defined benefit scheme. However, if the stock market falls, the pension holder can suffer heavy losses. The problem with such risk is that it is largely unknowable beforehand, hence the seemingly extreme caution from advisers.
It can be particularly frustrating for people who are adamant that they want to trade in their pension for a flexible income, only for their financial adviser to refuse to endorse their decision. The problem is that the adviser must assume responsibility when they sign off on a pension transfer, which could expose them to a potentially huge liability in the future. Understandably, many don’t want to run this risk, or can’t justify the level of insurance they would need.
In light of this high level of caution, it’s rather surprising to see a surge in a type of retirement advice that many would class as equally high risk.
Equity release – the practice of remortgaging or selling a share in one’s home in exchange for money up front – is soaring in popularity. In 2019 nearly £4 billion worth of property value was converted into cash to help fund people’s retirement years. The uptake of equity release has been reflected in the growth of the Equity Release Council (ERC), a body made up of providers and advisers that works to safeguard the interests of homeowners. In the past two years the ERC has nearly doubled in size, with the number of member firms leaping from 219 to 431.
Yet this is probably just the tip of the iceberg. The Office of National Statistics puts the UK’s property wealth at around £8 trillion, indicating a huge untapped market that providers will be eager to reach. With the average interest rate on lifetime mortgages now at an all-time low of 4.9 per cent, representing better value for consumers, the growth of equity release looks set to accelerate in the short term at least.
Homeowners above a certain age (usually 55 or 60) who own 100 per cent of their property can unlock part of its value using one of two methods. A lifetime mortgage is a loan, usually between 18 per cent and 50 per cent of the property’s total value, which will be repaid when the property is sold. Interest will compound over time, so the amount repaid will be significantly higher than the amount borrowed. However, homeowners can reduce the amount they must repay by paying off the interest as they go.
The other form of equity release is home reversion. Here, a portion of the home is sold (at significantly below market rate) in exchange for a lump sum or an income. The homeowner can continue to live there for as long as they wish, but the property must be cleared for sale soon after their death – usually within a month. The homeowner will miss out on any growth in the home’s value on the portion that has been sold.
In 2019 the provider Canada Life published research showing that although the use of equity release is growing, so is the public’s apparent ignorance of how it works. In 2016 just 5 per cent of people said they wouldn’t use equity release because they didn’t understand it; by 2019, this figure had tripled to 15 per cent. In reality, this is probably not a case of people becoming less informed. Rather, people are learning just enough about equity release to realise it is potentially risky, whereas previously they knew hardly anything and so were less wary of it.
Lack of understanding of equity release is now the second-biggest reason cited for not using it. The biggest is the fear of losing control over one’s home. This fear is in fact misplaced (equity release products from regulated sources will ensure that a person cannot lose their home while they are alive, and also that they will not go into negative equity).
Alice Watson, head of marketing and communications at Canada Life Home Finance, said: ‘Some people are put off the product because of comments by friends or family members, some of whom might inadvertently share incorrect or outdated information. It’s clear that the industry needs to work harder to address consumers’ myths and misconceptions.’
Nevertheless, two very real risks of equity release remain: firstly, that a homeowner will obtain far less value through a lifetime mortgage (or home reversion) than they would be selling the property on the opening market; and secondly, that most or all of the property’s value will be used up, leaving nothing for their children to inherit.
These two risk factors mean it is vital for homeowners to understand exactly how equity release works and to take independent advice on whether it is right for their particular circumstances. They must also consider which form of equity release to choose (if any) and be fully aware of the potential costs of doing so.
Other hazards lurk around equity release products, such as early redemption penalties. One couple in South Wales were told they must pay £16,430 if they wanted to move out of their bungalow, and that their £42,900 loan had increased to £119,391 due to compound interest. Another couple in north London unwittingly left their daughter with just a four-week deadline to vacate their home, having taken out a home reversion scheme. This scheme had also given them just £52,000 for a 90 per cent share in a house now worth over a million.
Equity release horror stories may be the exception, but they do happen. Another more common risk is that receiving a lump sum via equity release can end one’s entitlement to state benefits, in the way that a low regular income would not. This can significantly reduce the value people obtain from equity release.
Fears of another mis-selling scandal have promoted financial advisers to tread more carefully around final salary pension transfers. Given the potential for regret if homeowners lose their benefits, miss out on house price growth, or find they can no longer leave their home to their children, it will be interesting to see if similar caution starts to emerge around equity release.
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