01/10/08 Calculation of Cash Equivalent Transfer Values
01 October 2008
From 1st October 2008, trustees are responsible under new legislation for deciding the basis on which transfer values are calculated under their scheme. For defined benefit schemes the cash equivalent transfer value (“CETV”) is a value determined on actuarial principles using assumptions affecting the scheme. Trustees will now have to determine these assumptions to produce a ‘best estimate’ of the expected cost of providing the members’ benefits.
The Pensions Regulator has recently issued final guidance to help trustees of defined benefit schemes understand and comply with their new responsibilities.
The Best Estimate Method for Calculating a CETV
The legislation establishes a framework for the calculation of an ‘initial cash equivalent’ (“ICE”) which is adjusted if necessary to reach the final CETV. Trustees must seek the advice of the scheme actuary on the assumptions used to calculate the CETV and must place a value on the member’s accrued benefits together with any options and discretionary benefits that the trustees decide should be included.
The guidance states that trustees should be pragmatic and make ‘evidence based’ decisions that seem reasonable in the light of information and advice received from the scheme actuary. The Regulator notes that as the ICE and the scheme’s technical provision bases have different legal requirements, they will usually produce different results. However, the trustees should consider how the two bases relate to each other.
The assumptions that trustees should discuss with the scheme actuary include geographical, demographic or industry specific influences, the characteristics of the various categories of scheme membership and the impact of expert external data. Trustees must also consider their investment strategy, the scheme’s funding plan and the effects of inflation.
Options and Discretionary Benefits
Best estimates must include those options that can be exercised by members without the need for anyone else’s consent – provided that they serve to increase the CETV. These options commonly include cash commutation and early retirement. The guidance specifies that the calculations must not include options that would reduce the value of the CETV.
Trustees must also decide the extent to which discretionary benefits should be taken into account, having regard to any established custom for awarding them and any requirements for consent in their scheme rules (usually involving the employer). These typically include pension increases above the amount provided for by the scheme rules.
The Alternative Method for Calculating a CETV
The legislation allows trustees to calculate a CETV higher than best estimate and the guidance sets out some circumstances where they might consider this, including where the employer asks trustees to do so. In all circumstances trustees must consider whether it is proper to use the alternative method and this will normally include a consideration of scheme funding and the risks of prejudicing the security of remaining members. A CETV calculated on the alternative method must always be higher than the best estimate.
Reviewing Assumptions
The guidance requires trustees to monitor and review the appropriateness of the assumptions underlying the calculation of the ICE. The frequency of review will be influenced by practicality and cost, and the guidance notes that it would be reasonable for trustees always to review assumptions at the same time as a scheme funding valuation. Trustees should instruct their actuary to advise them when the ICE is no longer within a reasonable margin of best estimate.
Reduction of Cash Equivalents for Underfunding
Trustees may reduce the ICE provided they have obtained an ‘insufficiency report’ from the scheme actuary. Trustees can use a current GN11 report prepared before 1 October 2008 for this purpose until such time as it needs to be updated. An insufficiency report will usually be commissioned at the same time as the scheme funding valuation but trustees may request one at any time. The guidance suggests that this might be particularly appropriate in certain circumstances, including a weakening of the employer covenant or where economic conditions suggest a worsening of a deficiency since the last valuation.
Although trustees may reduce the ICE they are not obliged to do so. The guidance states that trustees should not automatically reduce the ICE where the scheme is underfunded, particularly where the employer covenant is strong and the recovery plan is not too long or where there are sufficient contingent assets available to plug a funding gap on employer insolvency.
The guidance provides that the scheme actuary may make reasonable allowance for winding up expenses and the priority order in producing an insufficiency report where the circumstances merit it.
Schemes in Wind-up or a PPF Assessment Period
The new legislation applies where a scheme is in wind-up. However, CETVs for schemes in wind-up cannot be reduced in accordance with an insufficiency report. Instead, they can be reduced to the extent necessary to comply with the legislative requirements for allocation of assets on wind-up.
Although trustees are not specifically exempt from providing CETV quotations where a scheme is in a PPF assessment period, the guidance clarifies that trustees will usually be acting appropriately if they inform members that transfers are not permitted under a PPF assessment period, and that the scheme will not be providing quotations.
Cash Transfer Sums
Early leavers with between 3 months and 2 years of pensionable service must be given the option of taking a cash transfer sum (“CTS”). The guidance notes that the same basis must be adopted for the calculation of CTSs as for CETVs.
Transfers-in
The method for treatment of these will normally be in the scheme rules but trustees will need to set assumptions within this for calculating the transfer credit. The guidance suggests that assumptions consistent with the transfer-out basis will usually be appropriate. Whatever assumptions are used, trustees should make these clear to potential transferring members.
Administrative Expenses
The guidance clarifies that trustees are permitted to reduce an ICE to reflect reasonable administrative costs associated with the transfer. However, any reasonable administrative savings for the scheme must be offset against any such costs.
Informing Members
The Regulator suggests that it would be good practice for trustees to disclose to members on request reasonable details of the relevant transfer basis (including the assumptions and the treatment of options and discretionary benefits).