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The Actuary The magazine of the Institute & Faculty of Actuaries

Commutation factors

Defined benefit pension schemes typically use a factor of 12 to determine the reduction in pension of those who take tax-free cash at retirement. This is a lot less than the projected cost of the pension given up; the reduction in the cost of benefits improves the scheme’s funding position and/or reduces the employer’s costs.

This practice is wrong. Trust law requires trustees to be even-handed between members, the fund, and the employer. Members taking cash should not be penalised. Even ignoring trust law, the practice is clearly inequitable and contrary to members’ reasonable expectations. Commutation factors should reflect the cost to the scheme of providing the pension given up, allowing for any uncertainties arising from the level of the funding of the scheme, and the covenant of the employer.

Actuaries advising trustees on the factor to use and our profession will both be in the firing line when consumer representatives understand what is going on. We must change the way in which we advise trustees. Urgent action is essential – for example in the form of guidance to members. The brief reference in the September issue of The Actuary was a start, but didn’t go nearly far enough.