Jon Forsyth of LCP outlines a new paper on commutation rates and explores what it’s like being a member of an IFoA working party
Over the last few years I’ve had the pleasure of being a member of an IFoA working party whose remit was to research commutation factors. These are the factors that determine the amount of tax-free lump sum that a member receives if they choose to give up some of the defined benefit (DB) pension at retirement.
These terms vary hugely between different pension schemes, often with good reason. But this can be confusing for members and lead to very different member lump sums for the same £1 pa of pension exchanged.
One aim of our working party was to drive more consistency in the way actuaries give advice, to improve decision-making and ultimately help ensure members are receiving fair value when they exercise this extremely popular option.
Our working party was formed off the back of the IFoA thematic review of actuarial factors. It included scheme actuaries from several of the larger actuarial pensions consultancies. We also had a professional trustee in the group, whose experience was invaluable as the one who often sets these terms in practice. We met regularly, often by video call but also face to face on some occasions. I really enjoyed the intellectual debate and challenge brought by the different opinions and points of view.
As you would expect we discussed a whole range of considerations including:
As part of all this we considered the different perspectives of trustees, sponsors, and members, as well as actuarial responsibilities and formal requirements.
You can read more about all of these in our full paper: Considerations for actuaries when advising on commutation rates (PDF, 300 KB). Below is a summary of our key takeaways.
The starting point for setting factors should be to use the same basis as is used for calculating cash equivalent transfer values in the scheme (CETV). After all, both options are exchanging pension for cash, and the aim of a CETV is to give members broadly the best estimate of what their pension is worth based on the scheme’s circumstances.
There are good reasons to deviate from this starting point in many cases, as we discuss in our paper. However, many of the common reasons cited for keeping terms low, such as ‘selection risk’ (arguing that members who have lower life expectancies are more likely to take up the commutation option, so factors should be more penal as a result) are sometimes used without justification.
We strongly believe any deviation from the starting point should be backed by evidence which is clearly communicated to clients. We also believe a comparison should always be made with the starting point factors so clients can see the impact of a different approach.
The best timing of a review depends on scheme circumstances. But terms should be reviewed more frequently than they currently are in many cases. 3 years should be an absolute maximum time between reviews. Schemes should also give more consideration to market-based factors, which vary more automatically as financial conditions change.
Advice should be clear, be tailored to the audience, and give clients everything they need to understand the decision they are making. In particular, more examples of impact on member benefits should be included in advice.
Of course, the world of pensions has changed somewhat since we started our research and indeed since we finished our paper, with higher gilt yields meaning much reduced transfer values and many schemes reducing commutation terms for the first time in many years.
But we believe our paper is still highly relevant in helping actuaries develop their advice in this area. Indeed, our call for schemes to give more consideration to market-based factors, which vary more automatically as financial conditions change, seems more relevant than ever.
We aren’t expecting readers to agree with all our conclusions. But we hope our paper will stimulate debate on setting commutation terms and perhaps challenge some current practices. We hope, of course, it will help actuaries in formulating the advice they give to their clients and the exercise of their professional judgement.
Lastly, I thought I’d share some quick takeaways on the experience of being part of the working party.
Firstly, a recommendation for anyone considering joining an IFoA working party – do it. Find an area you’re interested in (on the IFoA website, take a look at its practice areas) and take the plunge. Working parties are often putting calls out for members on the IFoA’s volunteer vacancies.
It’s a great way to give back to the profession as well as make a positive difference to your industry more generally. It’s also a great way to meet people from different companies and work together in a way you might not normally have the opportunity to do.
Do make sure you take it seriously and put the effort in – it will be worth it. It’s easy to let the day job take precedence (and sometimes of course it must). But ultimately you get out what you put in and you will enjoy the experience more if you get more involved. And hopefully others in the profession will benefit from your research.
When you get to the end, put a bit of extra effort in to get your message out there. You don’t want all your hard work to go to waste. Be proactive and work with the IFoA to advertise your content, be it a paper, seminar, webinar, or press release.
