Changes to the legislative framework which governs the calculation and payment of cash equivalent transfer values (CETVs) will come into force on 1 October 2008. The key features of the new regime are examined below, in light of draft guidance on the calculation of CETVs issued by the Pensions Regulator (the "Draft TPR Guidance").
Trustees will be responsible for the calculation of CETVs
Under the new regime, trustees will be responsible for the calculation of CETVs, including the selection of the underlying actuarial assumptions. This is in contrast to the current regime, under which the scheme actuary has a more pivotal role.
The actuary will no longer be required to certify CETVs but will advise as appropriate; however, overall responsibility for calculating CETVs will fall to the trustees
Timescales are unchanged
The CETV timeframe is not changed by the new regulations. The guarantee date for a statement of entitlement to a CETV must be within three months of the member's application. Where the trustees breach this for reasons beyond their control, the guarantee date must be within six months of the member's application.
Starting point for the calculation of a CETV: the "Initial Cash Equivalent"
Trustees must calculate and verify CETVs by first calculating the "initial cash equivalent" ("ICE"). The CETV must be at least equal to the ICE (unless it is reduced in accordance with the regulations – see below).
The ICE is the "best estimate" of the cash amount at the guarantee date which is required to make provision within the scheme for a member's accrued benefits, options and discretionary benefits. In calculating the ICE, the trustees must determine:
- The extent of any member options which would increase the value of his/her benefits. Options which may reduce the value of a member's benefit cannot be included; neither can options be offset against each other. The trustees should also consider non-standard benefits. The Draft TPR Guidance cites early retirement as an example of how options should be factored into the calculation of the ICE. Members who take early retirement often benefit from the application of early retirement factors which increase the value of their benefit. It is also possible that they would opt to commute their pension on early retirement, resulting in a small windfall for the scheme because of the commutation factors used. In this scenario, trustees cannot assume that the member who takes early retirement will also commute his pension. They can only assume that the member will benefit from the early retirement factors; they cannot factor-in the commutation factors which might act to reduce the value of the benefit.
- The extent of any adjustments to reflect the proportion of members likely to exercise those options.
- The extent to which discretionary benefits should be taken into account, in light of established custom and any consent requirements.
The Draft TPR Guidance advises trustees to make a decision in relation to each discretionary benefit. They should also take into account past history and future intentions as to the award of the benefit, in light of relevant circumstances (for example, the scheme's funding position). The Draft TPR Guidance also advises trustees to consider whether allowances have been made in the scheme's funding plan for any discretionary benefits.
Trustees must determine the assumptions on which the ICE is based
Trustees must determine the economic, financial and demographic assumptions on which the ICE is to be based, after taking actuarial advice.
- The Draft TPR Guidance advises trustees to consider whether a particular assumption is likely to be influenced by scheme-specific, industry-specific, and/or member-specific factors; and also suggests that the trustees may wish to sub-divide the scheme membership into groups with shared characteristics, if appropriate.
- Trustees must have regard to the scheme's investment strategy when choosing assumptions. This includes the expected investment returns. The Draft TPR Guidance states that assumptions as to investment returns which are used to derive the appropriate discount rates should be net of investment management fees and expenses.
- The Draft TPR Guidance states that assumptions used in the calculation of a scheme's technical provisions under the scheme-specific funding regime must be chosen prudently and that this will often mean taking a margin on the cautious side of the best estimate. The Regulator states that the technical provisions assumptions and the ICE assumptions should be capable of "rational reconciliation" (meaning that it should be possible, starting with the ICE assumptions, to demonstrate that funding assumptions are prudent).
- Hence, the Draft TPR Guidance notes that it will often be efficient for trustees to consider their CETV assumptions at around the same time as their technical provisions assumptions under the scheme-specific funding regime.
- The Draft TPR Guidance advises trustees to consider any non-standard benefits.
The Draft TPR Guidance encourages trustees to monitor and review the assumptions but also states that the frequency of that review should be influenced by practicality and cost. Hence, the Draft TPR Guidance suggests that a review at the same time as a scheme funding valuation might be appropriate.
In what circumstances can trustees reduce CETVs?
Trustees may choose to reduce CETVs from the ICE (but are under no obligation to do so) where a scheme is underfunded. The Draft TPR Guidance suggests factors for trustees to consider when deciding whether to reduce CETVs; for example, the degree of underfunding, the strength of the employer covenant and the contents of any recovery plan.
The Regulator does not expect trustees to reduce CETVs where the employer covenant is strong and where any shortfall is to be made up over a reasonably short period of time. In any event, CETVs cannot be reduced by more than the "deficiency percentage".
Before trustees can take a decision to reduce CETVs, they must first obtain an insufficiency report. This should usually be commissioned at the same time as a scheme funding valuation. This is because CETV reductions must cease when a new funding valuation is received by the trustees, meaning that the trustees must obtain a replacement insufficiency report at that point should they wish to continue to reduce CETVs. However, the trustees retain a residual discretion to commission an insufficiency report at any other time. Schemes which have not yet obtained a scheme-specific funding valuation can use the GN11 report in certain circumstances (for example, where the GN11 report has a recent effective date).
The insufficiency report is prepared by the actuary, in consultation with the trustees on certain issues (eg, whether to make allowances for winding-up expenses and/or whether to allow for different categories of benefit under the priority order). To reduce costs, the actuary may make reasonable approximations when preparing an insufficiency report; in particular, when estimating the Pension Protection Fund (PPF) compensation level.
The Draft TPR Guidance notes that the need for CETV reductions should diminish over time (for example, because of the effect of a recovery plan). To reflect this, trustees may set reductions at an appropriate percentage or reduce the level of reductions over time.
Administration costs can be deducted, but there must also be an offset for any administrative savings (for example, the cost of administering a pension in payment).
Can trustees increase a CETV?
Trustees may set a higher CETV (for example, if the employer asks) on such basis as the trustees themselves may determine. However, in reaching this decision the trustees should consider the funding position of the scheme.
Some special cases
The Draft TPR Guidance highlights some situations which affect the application of the new CETV regime:
- Schemes in wind-up. The new regulations apply but trustees should note that the investment strategy will differ markedly for a scheme in winding-up and this will be reflected in the calculation of the "best estimate" CETV.
- Schemes in a PPF assessment period. These schemes are not usually allowed to pay a CETV, although there is no explicit exemption from the requirement to provide a CETV quote (that is, a statement of entitlement). The Draft TPR Guidance suggests that it will usually be appropriate to inform members that, as transfers are not permitted, the scheme will not be providing these quotations.
- Members who are within a year of the scheme's normal retirement date. Schemes do not have to allow members who are within a year of their normal retirement date to take a CETV, but may do so if the scheme's rules allow it. Unless the trustees' approach is dictated by the scheme's rules in these circumstances, trustees have flexibility to decide how these transfer values are calculated.
- Cash transfer sums. Early leavers with between three months and two years of pension scheme service who do not qualify for a preserved benefit, must be provided with the option of a cash equivalent called a "cash transfer sum". The Draft TPR Guidance provides that the same basis should normally be adopted for the calculation of the cash transfer sum as for CETVs.
- Transfers-out after a transfer-in. Trustees should discuss the position with their actuary, as the transfer value offered in respect of previously transferred-in service can be lower than the original transfer-in received, or even lower than the value of the transferred-in service. The Draft TPR Guidance suggests that a popular approach in this situation is to provide some form of underpin, based on the original transfer adjusted for investment returns.