The way cash equivalent transfer values (CETVs) are calculated is about to change. From 1 October 2008, trustees of defined benefit occupational pension schemes will choose the assumptions that should apply to the CETV calculation, having first obtained the scheme actuary's advice. Currently, assumptions for CETVs are set by the scheme actuary following the, soon to be withdrawn, Guidance Note 11 (GN11). The Government decided to introduce legislation* to replace GN11. This followed concerns raised some years ago that, if implemented, draft revisions to GN11 put forward by the actuarial profession would have increased CETVs significantly and would have led to more transfers-out from defined benefit schemes.

Under the new requirements, CETVs must not be lower than a minimum level but can be higher, so long as the trustees have acquired any consent needed. The ability to reduce the CETV in recognition of scheme underfunding (and in certain other circumstances) will continue. A few changes will also be made to the disclosure obligations that apply to transfers. Although the Pensions Regulator's guidance for trustees has not yet been finalised, from the information available to date it appears unlikely that the new requirements will have any legal impact on incentivised transfers.

What does this mean for trustees?

Trustees should start thinking about their responsibility to set the assumptions. If they are to be in a position to meet the new requirements in time for statements of entitlement (SOE) provided from 1 October onwards, trustees should be having discussions with their actuaries now. It's worth noting that:

  • The three month deadline for providing the SOE still applies. For any existing SOE requests (or any made in the next few weeks) it is worth establishing whether the new requirements will apply (in other words, when is the SOE likely to be issued?)
  • The new legislation does not allow for a transitional period but there is some scope for trustees to provide the SOE after the three month deadline. This will still be for a period of up to six months from the date of the member's application where the trustees couldn't meet the deadline due to "reasons beyond their control".

The Pensions Regulator has just published some draft guidance for trustees on the new requirements. The consultation runs until 19 September, so the final version will not be ready much before, if not after, 1 October. In view of this, trustees who have already decided how they will proceed may need to revisit matters

Extra disclosure information will also need to be included for SOEs issued after 1 October, so any standard SOE wording should be updated to include this.

Trustees should remember that these changes apply to CETVs. For anyone who falls outside of the requirements that must be met before they can request an SOE under the legislation (broadly speaking, someone whose pensionable service ended during the year before normal pension age), the new transfer value laws will not apply, even if the scheme rules allow transfers for such members. However, the draft guidance says that the Pensions Regulator would expect schemes to use the same basis of calculation for non-statutory transfers as that set out in the legislation for CETVs.

How is the CETV calculated?

Before any account can be taken of any under-funding, an initial cash equivalent (ICE) must be calculated. The ICE is the amount that is needed "to make provision within the scheme for a member's accrued benefits, options and discretionary benefits". The assumptions that the trustees should use must:

  • Be economic, financial and demographic assumptions. Demographic assumptions must involve taking into account the main characteristics of the scheme's members or, where there aren't enough members to enable this, of a wider population sharing similar characteristics.
  • Be chosen after taking the actuary's advice, and as a whole should lead to a "best estimate" of the ICE.
  • Take the scheme's investment strategy into account when setting the assumptions used for calculating the member's discount rates. The draft guidance suggests that the scheme's funding strategy should be discussed with the actuary as potentially relevant to the investment assumptions underlying the ICE.
  • Be reviewed – perhaps at the same time as each scheme funding valuation and where circumstances might justify a review at other times. For example, where there is a significant change in investment policy.

To make provision for the member's options and discretionary benefits the trustees must:

  • Work out which options open to the member would increase the value of his or her benefits. The draft guidance says that any options that would reduce the value of the member's benefits should not be used to offset added value options.
  • Establish the extent of any adjustments they decide to make to reflect the proportion of members likely to take up those options.
  • Decide the extent to which they will take any discretionary benefits into account, having regard to any established custom for awarding them and any requirement for consent before they are awarded. The draft guidance suggests that trustees should consult the employer before making a decision on this where the employer has the discretion to award discretionary benefits. Currently, discretionary benefits are automatically included in the calculation unless the trustees direct otherwise, after having obtained a written report from the actuary.

Is an alternative method of calculation available?

The new regulations allow trustees to use an alternative route to that of the ICE (in some cases the scheme rules will require this). If they decide to go down that route then the CETV must be higher than it would have been had the ICE calculation, after adjustments, been used. The trustees must also have regard to any requirement for consent in these circumstances. It will still be open to trustees taking this alternative route to make adjustments, for example, reductions in the light of scheme underfunding.

How can the ICE be adjusted?

The trustees may choose to reduce the ICE where they have asked the scheme actuary for an insufficiency report and that report shows that the scheme's assets were insufficient to cover both liabilities in respect of all members and any category of liabilities for benefits in respect of which the member's CETV is being calculated. Trustees are not obliged to reduce the ICE in these circumstances and should take various factors into account before reaching a decision (for example, the strength of the employer's covenant and whether there are any contingent assets in place). Where the trustees do decide to make a reduction, they can reduce any part of the member's ICE payable in respect of an equivalent category of liabilities. However, the reduction can't exceed the percentage by which the assets were shown to be insufficient for that category of liabilities. It may be that in certain circumstances it would be appropriate for the trustees to seek a top-up payment from the employer so that the CETV actually paid across is the same as it would have been without the reduction. Taking this approach would ensure that the scheme's funding in respect of the residual members is unaffected and for those employers who are keen to maximise the number of transfers out from their schemes this may be an attractive option.

The draft guidance says that it will usually be convenient to commission an insufficiency report at the same time as a scheme funding valuation. Insufficiency reports may be commissioned at any other time in certain circumstances – for example, where the employer's covenant appears to have weakened. The guidance goes on to say that any reductions must stop as soon as a fresh funding valuation is received. At this point, the reductions can only continue if the trustees receive a replacement insufficiency report with an effective date no earlier than that of the new valuation.

Trustees will be allowed to use the first GN11 report as the insufficiency report where the scheme has not yet had its first scheme funding valuation, but only where the assumptions are close enough to those adopted by the trustees under the new requirements and either,

  • the actuary says that any resulting maximum reductions would not be materially different from those that would result from an insufficiency report, or
  • the trustees want to reduce the ICE by less than the maximum allowed and the actuary advises that the GN11 report will support the appropriateness of any reductions

Various other reductions that currently apply (for example, in relation to protected rights, or where the scheme has started to wind up) appear in the new regulations too. The ICE can also be reduced by any reasonable administration costs that would arise if the member were to leave the scheme, but if the trustees decide to do this they must offset against this any reasonable administrative savings.

Will the SOE need to contain extra disclosures?

A few extra disclosures will need to be made as a result of the new requirements. Equally, some items on the current list of required disclosures will no longer apply from 1 October. In part this is due to the change regarding discretionary benefits. Apart from telling the member about the FSA, the Pensions Regulator, the Pensions Advisory Service and the Pension Protection Fund (where the scheme is eligible for PPF entry), there should also be a recommendation that the member take financial advice before reaching a decision about transferring. Recommending financial advice is something that comes up regularly in the Pensions Regulator's guidance on inducement offers. The draft CETV guidance says that it would be good practice for trustees to disclose the transfer value basis (including the assumptions) on request and to tell members which options and discretionary benefits are included in the CETV.

How are transfers-in affected?

Transfers-in are not covered in the new legislation, but are dealt with in the draft guidance. There is no statutory requirement for trust-based schemes to accept transfers-in and the calculation of a transfer credit is usually dealt with in the scheme rules. While the draft guidance says that choosing best estimate assumptions for the cost of providing the benefits within the scheme will usually be appropriate, the Pensions Regulator also acknowledges that it would be appropriate for trustees to take account of the fact that this option will be especially attractive to those members who expect their pay to increase above average rates.

Is there likely to be an impact on incentivised transfers?

The new requirements will still allow schemes to pay enhanced transfer values. The requirement for any consent to be obtained should not pose problems since the idea for the inducement will most likely have come from the employer anyway. It seems unlikely that the new requirements will have any significant legal impact on inducement offers. For employers who are keen to increase the number of transfers out from their schemes, topping up CETVs which would otherwise be reduced to reflect scheme underfunding may continue to be an attractive option. The extra disclosure requirement for trustees to recommend that members take independent financial advice dovetails with the Pensions Regulator's guidance on inducement offers, which repeatedly refers to this. The inducement offers guidance goes further, however, by suggesting that trustees may wish to seek to persuade the employer to pay for the advice, so long as the independence of that advice is not compromised.