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03 September 2008

Regulator consults on eleventh hour CETV guidance for trustees

The Pensions Regulator issued a consultation paper on 8 August 2008 containing draft guidance for trustees on the calculation of cash equivalent transfer values (CETVs).

The purpose of the guidance is to help trustees make the decisions required of them by the new regime to be introduced by The Occupational Pensions (Transfer Values) (Amendment) Regulations 2008 from 1 October 2008.

See our In Focus for a summary of the new CETV regime.

Comments

The consultation period runs until 19 September 2008.  So, at best, the guidance will not be finalised until a few days before the new regime comes into being!

On the face of it, there could be many formalities to go through before a scheme's trustees can determine their CETV assumptions, particularly where there are numerous discretionary benefits or non-standard benefits to be considered.

Other commentators have said the number of trustee decisions required could present a problem given the lack of time that will be available after the guidance has been finalised.  However, most schemes will still be in deficit and are unlikely to be granting discretionary benefits for the time being.  So, we suggest a pragmatic way forward in many cases would be to determine assumptions that reflect the benefits currently being granted.  The circumstances in which variations to cope with possible discretionary benefits could then be considered in the coming months.

We are also not convinced that it will normally be necessary for trustees to devote their time to giving detailed consideration to all non-standard benefits (eg nuances of individual members) up front.  If trustees adopt a principles-based approach, it should be possible to address any CETV requests from members with non-standard benefits easily and quickly if and when the need arises.

While the Regulator suggests detailed consideration of a number of items, many of these (eg identifying the discretionary benefits that can be granted) will already have been considered as part of the scheme's latest scheme-specific funding valuation.  So, a review in the context of CETVs can simply piggy-back on the earlier valuation exercise.

As suggested in our In Focus, trustees should note the contrast between the scheme-specific funding regime, which requires them to set assumptions prudently, and the new transfer value regulations that will require them to set "best estimate" assumptions.  This may encourage trustees to be more explicit about where they are building prudence into their funding assumptions and may lead to explicit contingency margins being introduced.

Although most of the guidance makes eminent sense, we struggle to understand the rationale for saying the expenses of wind-up should only be factored into an insufficiency report if a wind up is either imminent or the sponsor is likely to become insolvent.  The point of reducing ICEs is to avoid favouring transferees at the expense of stayers should the scheme have to be wound up, so we believe it would be logical to factor in wind-up expenses regardless of how likely a wind up is thought to be.

Summary

For ease of reference, we summarise the draft guidance below under the same headings, in the same order, as used in our In Focus, with a couple of additions.  (Once the guidance has been finalised, we will consolidate it into the In Focus.)

Minimum level of initial cash equivalents (ICEs)

In relation to the ability to adopt an alternative approach to the calculation of ICEs that does not represent the "best estimate cost":

  • If the employer who has requested the trustees to adopt a more generous calculation than the minimum, the trustees must consider whether it is appropriate for them to do so, bearing in mind they may need both actuarial and legal advice and they may need to consider how well the scheme is funded relative to the statutory funding objective and how quickly any shortfall is being made good.
  • Trustees should ensure that any CETV calculated on the alternative basis that has been reduced for underfunding is no lower than the (reduced) CETV on the minimum "best estimate" basis.

Determination of assumptions

Trustees should recognise that the "best estimate" concept is not precise and they will often need to be pragmatic and accept choices that seem reasonable to them in the light of information and advice obtained.

When determining assumptions, trustees should discuss various issues with their actuary, including:

  • whether particular assumptions are likely to be influenced by scheme-specific, industry-specific and/or member-specific factors (eg industry and geography in relation to mortality and the scheme rule on who is eligible to receive a dependant's pension for the proportion of members leaving a dependant)
  • the main characteristics of the scheme's membership, when it comes to demographic assumptions
  • whether it would be appropriate to sub-divide the membership into groups with shared characteristics
  • relevant external data, such as trends in mortality rates and longevity
  • expert opinions on past relationships (eg between bond and equity returns) remaining valid in future.
In relation to making assumptions about future investment returns, trustees should:

  • discuss the relevance of the scheme's funding plan with their actuary
  • consider consulting their investment adviser about economic conditions and the implications for selecting best estimate investment returns.
Trustees' decisions should be objective and based on evidence, including:

  • past history of investment returns from different asset classes and the relationships between them
  • published mortality tables
  • for larger schemes where it is statistically reliable, the scheme's own demographic experience
  • published statistics on proportions married and the relative ages of partners
  • the opinions of recognised experts
  • the output from any stochastic models used by the actuary.
It will often be efficient for trustees to consider their CETV assumptions at the same time as the assumptions underlying their scheme's technical provisions, ie as part of the valuation process.  It should be possible to reconcile the two sets of assumptions rationally.

Once set, trustees should monitor and review the appropriateness of their assumptions, with the frequency of review being influenced by practicality and cost.

It would be reasonable for trustees always to review assumptions in conjunction with a scheme funding valuation, although reviews between valuations should be considered where the ICE is no longer within a reasonable margin of materiality of a best estimate.  Accordingly, trustees should instruct their actuary to alert them when this is likely to be the case.

Circumstances justifying a review between valuations include:

  • a significant change in investment strategy
  • a change in policy regarding the exercise of discretions
  • becoming aware of significant differences between actual and expected demographic experience
  • the publication of new mortality tables or other information in mortality.

Even if trustees decide to incorporate some form of adjustment based on market yields in the calculation of ICEs, they should still monitor whether the assumptions remain appropriate in changing market conditions.

Allowance for members' options and discretionary benefits

In relation to options:
 

  • As only those options that would increase the value of benefits may be included when calculating a CETV, trustees will need to take advice from their actuary over which options would increase an ICE.
  • Trustees may allow for the chance that the member will not take up such an option, based on their view of the scheme's likely future experience, informed by past experience of members taking it up.
  • Where an option that increases the ICE is included, trustees should not offset that by another option that would on its own reduce that ICE.
  • Options that require [trustee and/or employer] consent should be treated as discretionary benefits.
When considering the extent to which discretionary benefits are to be included, trustees:

    • should make a decision in relation to each discretionary benefit they can provide under the scheme's rules
    • should understand the relevant scheme rule that provides for the award of the discretionary benefits in question, bearing in mind they may need to take legal advice
    • may wish to consult any person (eg the employer) whose consent is required
    • should consider the past history and future intentions with regard to the award of the benefit, taking into account the relevant factors on which decisions are based (eg the scheme's funding position)
    • should take into account any agreed policy relating to the award of that benefit
    • should consider whether allowance for discretionary benefits is made in the scheme's funding plan (either explicitly or implicitly through margins for prudence), bearing in mind they may require the actuary's advice.
    In relation to both options and discretionary benefits, trustees should ensure they consider, not only all the standard benefit structures within the scheme, but usually also any non-standard benefits that may require separate consideration.

    Allowance for administrative costs

    Trustees may reduce the ICE quoted to the member to take account of the administrative costs that would arise were the member to transfer his or her benefits out of the scheme.  The administrative cost savings that must offset such costs will be the discounted value of the expected cost of:

    • administering the deferred pension up to retirement
    • dealing with a deferred member's retirement
    • administering the member's pension and contingent dependant's pension after retirement.
    Where a reduction is applied, it must be disclosed when providing the member's Statement of Entitlement.

    Reductions for scheme underfunding

    The preparation by the actuary an insufficiency report on the trustees' instructions should not in itself be taken as a recommendation that CETVs should be reduced.  Indeed, it is suggested trustees should not normally reduce CETVs where the employer's covenant is judged to be strong and any funding shortfall is being remedied over a reasonably short period of time. 

    Before deciding whether it is appropriate to reduce CETVs, the trustees should take into account:

    • the degree of underfunding
    • their assessment of the strength of the employer's covenant - the stronger the covenant, the less likely the trustees may feel it necessary to reduce CETVs
    • the structure of any recovery plan that has been put in place - the quicker a funding shortfall is being addressed, the less necessary reductions may be
    • whether any contingent assets have been put in place and, if so, their form
    • whether the employer has undertaken to  make a compensatory payment into the scheme each time an unreduced CETV is paid.
    In addition to preparing an insufficiency report, trustees should, as appropriate, ask their actuary to advise them on the implications of:

    • not reducing CETVs where a reduction is permitted and/or
    • applying a lesser reduction than would be permitted.
    An insufficiency report is not required where trustees do not wish to consider reducing CETVs.

    A need to increase the degree of reduction (and hence a need for a new insufficiency report) between actuarial valuations may arise in certain circumstances, which include:

    • an apparent weakening in the strength of the employer's covenant
    • an increase in the scheme's funding shortfall, eg due to a worsening of economic conditions.
    Where a scheme is underfunded and a recovery plan has been put in place, its funding level can generally be expected to improve over time, which would diminish the need to reduce CETVs.  This means the level of reduction applied to CETVs shortly after an actuarial valuation may no longer remain appropriate throughout the entire period until the next valuation.  To address this, trustees could:

    • commission further insufficiency reports as and when the actuary suggests the funding position has improved by an agreed margin
    • set reductions expected to be appropriate on average between valuations (they do not always have to be at the maximum permitted level) or
    • set reductions at the full level permitted by the insufficiency report, but decrease these at intervals based on approximate calculations by the actuary.
    Although not a legal requirement, trustees should expect their actuary to discuss various aspects of the preparation of an insufficiency report.  In particular, the actuary should discuss the appropriateness of including an allowance for the cost of winding up the scheme, which depends on:

    • whether the scheme is expected to enter wind up shortly
    • whether the employer's covenant is acknowledged to be very weak, making a wind-up a significant possibility in the near term.
    Another aspect for discussion is whether to allow for the statutory priority order on wind-up.  It is suggested it should usually be assumed that taking account of the priority order is the most equitable treatment, unless combining categories would not give rise to significantly different degrees of reduction in the ICE for any member.

    The actuary should also discuss the nature of any approximations to be made in the calculations.

    A transfer payment for a member's former spouse following divorce can only be reduced if the former spouse (or civil partner) has been offered and refused an unreduced pension credit within the scheme.

    Non-statutory transfers

    The same basis should normally be used for non-statutory transfers as for statutory transfers.

    Inward transfers

    Where schemes are still accepting inward transfers and offering defined benefits, it will usually be appropriate to choose best estimate assumptions for the cost of providing those benefits.  However, where there is potential for "selection" against the scheme (eg the offer of "added years" being attractive to members who expect their pay to increase faster than average), it would be appropriate for trustees to take this into account.

    Although in general assumptions should not vary between members, account may be taken of  identifiable characteristics expected to affect the eventual cost of benefits granted and could include:

    • the marital (or civil partnership) status of the member and the age (and sex) of the spouse or partner
    • the member's employment category.
    Where a pension credit is being granted within the scheme following a member's divorce, the benefits awarded must be consistent with those granted in respect of inward transfers.

    Trustees should discuss with their actuary how to deal with any member who was granted added years and is subsequently looking to transfer out of the scheme.  A common approach is to apply an underpin to the CETV based on the original transfer payment received adjusted for investment returns.

    Disclosure to members

    It would be good practice for trustees to:

    • make available reasonable details of the scheme's relevant CETV basis (including underlying assumptions) on request from a member or a member's financial adviser
    • provide with Statements of Entitlement a note of which options and discretionary benefits have been included in the ICE where the best estimate method is adopted.

    Trustees should continue to ensure that the amount of any CETV relating to Guaranteed Minimum Pensions or post-97 contracted-out salary-related rights are identified.

    Schemes in wind-up

    The new regime applies to schemes in wind-up.  However, such schemes cannot reduce CETVs in accordance with an insufficiency report; they should instead comply with the legislative requirements for the allocation of assets on a wind-up, which will dictate the extent to which reductions can be applied.

    Schemes in a Pension Protection Fund (PPF) assessment period

    Although not exempt from being required to provide quotations (Statements of Entitlement), schemes being assessed for entry to the PPF are not normally allowed to pay CETVs.  However, unless needed for pension sharing on divorce, it will usually be appropriate for schemes to inform inquiring members that quotations will not be issued.  Where this is the case, provided members have been kept informed, the Regulator will not seek to take action.

     

    Additional Links

    For further information:

    Gary Tansley
    Tel: 01737 841 732
    Email: enquiries@hamishwilson.com

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