Chris O’Brien takes us though the legal constraints affecting the way in which pension trustees deal with commutations. And should commutation factors be reviewed more frequently?
Pensions actuaries who are advising trustees need to consider the law and regulations applying to pension schemes. But what do they do when no regulations apply? This is the case when members opt to take part of their defined benefit pension as a lump sum instead of an annuity – known as pension commutation.
The key question is the commutation factor that trustees should use; in private-sector schemes, this is generally at their discretion. The rules usually refer to taking actuarial advice into account but do not provide any further guidance on how to actually give this advice.
While we do not expect all schemes to use the same factors, the possible range is wide. The survey carried out as part of the IFoA’s 2020 thematic review on pension factors revealed that commutation factors for converting a £1 pa pension at age 65 varied from about 9 to over 30. Do actuaries understand the constraints on trustees’ discretion, which derive from trust law in general? What are the main issues, and should factors be reviewed more frequently?
Principles for trustees
The principles applying to trustees’ decisions, derived from David Pollard’s book Pensions, Contracts and Trusts: Legal Issues on Decision Making, are:
- Trustees must act honestly: in other words, in good faith
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No unauthorised conflict: trustees are fiduciaries (but may be scheme members)
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Discretion must be exercised for a proper purpose
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Trustees must act with due care and skill
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Trustees’ decisions must be made by the specified person, in the specified way, at the specified time.
It is useful to expand on Principles 3, 4 and 5.
Principle 3: Discretion must be exercised for a proper purpose
The purpose of the commutation option is to allow scheme members to exchange an annuity for a lump sum, and the trustees have discretion when it comes to the rate of commutation. It is therefore reasonable to think that the discretion is there to allow trustees to consider relevant matters such as demographic and financial conditions (implicit in the reference to taking actuarial advice into account), and the interests of the employer and members. However, this isn’t very specific.
Principle 4: Trustees must act with due care and skill
There are two parts to this:
- The process requirement is that trustees use due consideration and consider the reasonably discoverable and relevant factors
- The outcome requirement is that the decision must not be perverse, capricious or irrational. The court can interfere if trustees come to a conclusion so unreasonable that no reasonable set of trustees could have come to it.
But what are relevant considerations when trustees are deciding on commutation factors? The starting point is likely to be the actuarial value of the pension being commuted. Exactly what this means is beyond the scope of this article, but questions arise, such as whether the cost of buying out the pension with an insurer is relevant. What about the transfer value or the technical provisions basis? Is the composition of the fund assets relevant or should bond yields be used in discounting?
Another question is whether commutation factors could be reduced because the cash is tax-free. Some actuaries appear to have considered this. Others might query this; if factors are reduced by the basic tax rate, is it fair that the tax-free cash remains as an advantage only for higher rate taxpayers? Trustees are expected to act fairly.
The thematic review suggested that some actuaries have considered that commutation is only an option: a member who thinks the terms are unsatisfactory can just take the full pension. A 2013 Pensions Ombudsman decision concerning Nissan may support this but it is open to debate.
Principle 5: Trustees’ decisions must be made by the specified person, in the specified way, at the specified time
Lastly, trustees must act within the terms of the power they have: the decision must be made by the specified person, in the specified way and at the specified time – but what time should that be? Pollard asked: why is that not an obligation on trustees to set commutation rates only at the right time (in other words, when requested)?
In a bulk transfer value case in 1982 concerning Fisons, the calculation had been done in March when a sale agreement for the business had been entered into, but the actual transfer took place after the trustees made their decision in December. In the intervening period, share prices increased significantly. The judge’s conclusion was that it might have materially affected the trustees’ decision if they had known the then-current value of the fund. In other words, a material change in conditions before the decision date could not be ignored.
Again, the judge in the Imperial Group bulk transfer case of 1990 emphasised that it was the circumstances at the time of the decision that were to be considered. A judge in a 2017 case concerning scheme benefits at IBM quoted this and applied it in forming his judgment. While these cases referred to an employer’s discretionary decisions, I suggest the conclusion would apply similarly to discretion exercised by trustees.
Should commutation factors be reviewed more often?
On the other hand, the thematic review found that, in most cases, the commutation factors advised “were to be fixed for the period up to the next review, which may be up to three years away… typically [for] administrative simplicity and member understanding.” In 2016 the IFoA issued a Risk Alert emphasising the importance of keeping commutation factors current. Are factors nearly three years old really ‘current’? Trustees may adopt certain working rules to help ongoing administration but need to check that they remain suitable to apply when the discretionary decisions are actually made.
Courts accept that their rulings must recognise practical problems but may question why there can’t be a streamlined process for updating factors every month rather than every three years. Perhaps keeping factors unchanged for a lengthy period helps members’ understanding and financial planning, while also avoiding any problems that may arise if gilt yields spike as they did in September 2022. However, defined contribution schemes must cope with market changes.
Indeed, if factors are constant for a long period and then change substantially, it can be harder to explain and more disruptive to members’ financial planning. Employers may also pressurise trustees not to make a large change if it means a significant increase in their costs. Trustees may choose lower commutation factors than the actuary advises, and members might be concerned if they know about this.
Returning to the need for trustees to use relevant considerations, if a member retires in June 2023, are financial conditions in July 2020 really a relevant consideration? This looks very strange – especially if, for members retiring in July 2023, conditions in July 2023 suddenly become relevant.
Actuaries may wish to ensure that their checklist for advice to pension trustees includes complying with not only regulations, but also the requirements of trust law.
Chris O’Brien is a retired actuary and a former director of the Centre for Risk and Insurance Studies at Nottingham University Business School
