2.1. The Thematic Review 2020

The report of the IFoA thematic review (Gordon, Reference Gordon2020) included benchmarking commutation factors and transfer values, as provided by 12 organisations. The commutation factors referred to a pension at age 65, increasing at RPI-based indexation up to 5% p.a., and were based on market conditions as at March 2020. The transfer values were on a similar basis, although with a 50% spouse’s pension from the date of death. The review covered factors for both females and males.

The median transfer value factor was 29, i.e. £29 per £1 p.a. pension. The spouse’s benefit was said to be around 12.5% of the transfer value, implying that the transfer value factor in relation to the member’s pension only was around 25–26. In contrast, the median commutation factor was 18. Since both transfer value and commutation involve exchanging pension for cash, a question arises: why are transfer values about 40% higher? Further, the range of commutation factors was wide: they might be about 10 or might exceed 30. It should be added that in nearly 30% of cases, the trustees chose a commutation factor different from what the actuary advised, this being especially common where the factor was low. The report recommended further research, and the actuarial profession established a working party to pursue this; its report (Hilsden et al., Reference Hilsden, Berriman, Crocker, Fish, Forsyth and Lindsay2023) is referred to in Section 6 et seq.

It is of interest to compare the commutation factors used by the Pension Protection Fund (PPF), which are designed to be actuarially equivalent. The thematic review found a median commutation factor of 18, whereas the corresponding PPF factor at March 2020 was 24.50, albeit with CPI – as opposed to the RPI-based indexation in the thematic review. From 1 October 2023 the PPF factor was 18.43.

The calculation of transfer values is subject to regulations drawn up by the Department of Work and Pensions (DWP), albeit not applicable to transfers near retirement. Transfer values are the discounted value of pension payments, using a best estimate of future mortality, and discounting at the best estimate of the rate of investment returns on the fund. The regulations make provision for paying higher transfer values if appropriate, and for reducing values dependent on the scheme funding. There is, though, no regulation on how commutation factors should be calculated.

Since March 2020, the time when the thematic review data apply, mortality rates and interest rates have increased; comparing commutation factors and transfer values today may well produce somewhat different results.

2.2. Earlier Evidence and Standards

Comments on commutation factors appearing to be lower than might be justified on actuarial grounds have appeared in the past. An article in the Financial Times referred to “outdated factors that do not represent the true value of income in order to reduce their [scheme] liabilities” (Harrison, Reference Harrison2004). Later that year, the Actuarial Profession Pensions Board (2004) drew attention to the dramatic fall in annuity rates and commented, “It appears that in many defined benefit schemes there may be a good debate to be had with trustees about the degree to which it is necessary and appropriate to move tax-free cash commutation factors in sympathy with the annuity or gilts markets.” Turvey (Reference Turvey2005) wrote that “this brief reference … didn’t go nearly far enough,” complaining that actuaries’ typical practice of using a commutation factor of 12 was wrong. He argued that trustees were not being even-handed between members, the fund and the employer and that the practice was “clearly inequitable and contrary to members’ reasonable expectations.” His view was that 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.”

The subject was addressed by the Member Options Working Party (2006). It commented that “there may be an assumption, possibly implicit, that these financial terms relate closely to the cost of replacing the benefit forgone.” In practice, commutation factors produced cash sums much less than a life insurer charged for providing the pension exchanged. Typical factors for a male at 65 where the pension increased with Limited Price Indexation up to 5% p.a. were 10–14, though some schemes had factors at market rates, such as 18 or 22. Some factors had not increased over the previous five years despite the fall in mortality rates and in long-dated interest rates.

The working party made a number of recommendations to the profession’s Pensions Board, which adopted them and circulated them to members (Actuarial Profession, 2007). These included:

• where an actuary has an explicit or implicit obligation to advise on member options, changes in market conditions (e.g. long-dated interest rates and longevity) may make it appropriate for the actuary to advise that the terms may be outdated and should be reviewed if not done in the past two to three years

• it may help clarify the actuary’s ongoing obligation for terms of engagement to include the terms for reviewing member options and establishing a policy for future reviews.

The profession issued a press release, “Pensioners may be short-changed over cash sum.” The Pensions Board also wrote to the DWP and The Pensions Regulator (TPR) to express concern that members taking cash may not have a clear idea of the benefits they are giving up and urged them to consider a risk warning, suggesting that members take financial advice if thinking of commuting a large amount of pension. They also proposed considering disclosure of the cost of replacing the benefit forgone. The Pensions Board met TPR, which expressed interest in general governance and trustee guidance rather than anything specific to cash commutation (Tompkins, Reference Tompkins2008).

A later article in the Financial Times (Cumbo, Reference Cumbo2012) was headed “‘Short-changed’ over pension lump sums,” although those quoted differed in their views. A survey carried out in 2012 showed a third of commutation factors were below 13 and a third above 16; in comparison, the typical annuity value was 18 (Smith, Reference Smith2013; the specification of the survey was not given).

Greater formality for actuaries came on 1 April 2011, when a Pensions Technical Actuarial Standard was applied to actuarial factors. This included a non-exhaustive list of relevant factors for assumptions, including the financial and economic outlook, and mortality and other demographic projections. Technical Actuarial Standard 300 (Pensions) applied from 1 July 2017: the information the actuary was to provide to trustees was to include the circumstances in which actuarial factors should be reviewed.

The IFoA (2016) issued a “Risk Alert,” explaining that falls in mortality rates and yields “have emphasised the importance to trustees, sponsors and particularly members of keeping commutation factors current.” The Joint Forum on Actuarial Regulation (2016) found that most reviews of commutation factors were done as part of the valuation cycle. Notable was the finding that some trustees/sponsors were reluctant to increase factors because of affordability concerns. More recently, the Joint Forum on Actuarial Regulation (2020) noted that commutation factors may not operate in members’ best interests.

Hence, the actuarial profession has been aware of the need to consider mortality and financial trends and to keep commutation factors current, although without precision on the frequency of reviews, while concerns of employers about higher costs from higher factors are apparent.

3.1. Legal Principles: Introduction

Trustees of pension schemes are subject to trust law, much of which was developed in the context of a typical trust being a discretionary trust for assets donated by an individual with a view to them being distributed to family members. However, trust law also covers commercial trusts, including pension schemes. In applying trust law, courts will consider the particular circumstances of the trust, such as its size and the relationship between the donor of the assets and the recipients of the benefits. Browne-Wilkinson V-C said in Target Holdings (1996) that commercial trusts remain subject to the basic principles of trust law, although the rationale for special rules developed for traditional trusts may not apply. The presumption remains that the usual trust law rules apply equally to pension schemes, for example as referred to in Mineworkers (1985).

Pollard (Reference Pollard2020, 2.14) set out the principles applying to trustees’ decisions as:

1. (1) trustees must act honestly, i.e. in good faith

2. (2) trustees must act within the terms of the power: by the specified person, in the specified way at the specified time (a “power” refers to the ability to alter legal relations between parties: Law Commission, 2014, 3.14)

3. (3) must be done for a proper purpose

4. (4) there must be no unauthorised conflict: the trustees are fiduciaries

5. (5) the trustees must act with due care and skill: with due consideration; considering the reasonably discoverable and relevant factors; and not be perverse, capricious or fully irrational (the “no reasonable decision-maker” rule).

Items (3) and (5) are of particular importance for commutation factors and are discussed in more detail in Sections 4 and 5, respectively. Items (1), (2) and (4) are reviewed below, although the subject of “the specified time” is particularly important and is discussed in Section 8.

3.2. Good Faith

The good faith requirement for trustees is clear from case law. For example, Robert Walker J stated in National Trust (1998) (not a pensions case): “Trustees must act in good faith, responsibly and reasonably.” This does not define trustees’ responsibilities precisely because the term ‘good faith’ can be used in different ways; Pollard (Reference Pollard2020, 3.9) used it in its subjective limited meaning of honesty.

Courts have recognised the special nature of employment contracts. In Imperial Group (1991) Browne-Wilkinson V-C referred to the comment in Woods (1981) that, in every contract of employment there is an implied term: “that the employers will not, without reasonable and proper cause, conduct themselves in a manner calculated or likely to destroy or seriously damage the relationship of confidence and trust between employer and employee.” He referred to this implied term as “the implied obligation of good faith.” He continued, “In my judgment, that obligation of an employer applies as much to the exercise of his rights and powers under a pension scheme as they do to the other rights and powers of an employer.” This is known as the “Imperial duty of good faith.”

Although Imperial Group (1991) referred to a decision of an employer, it is reasonable to think that the courts would apply the same principle to trustees acting in relation to a pension scheme. Three such cases can be referenced: in British Airways (2018) Patten LJ referred to the need for trustees to act in good faith; in Edge (2000), the Pensions Ombudsman’s comment that the trustees had a duty to exercise a discretion fairly and honestly was noted; and in Mineworkers (1985), Sir Robert Megarry V-C said, “Powers must be exercised fairly and honestly.”

While it is unusual to find a lack of good faith in pension cases, it can happen. Knox J considered the Imperial Group (1991) case in Hillsdown (1991), where the employer threatened to add new categories of employee while not paying employers’ contributions; the judge regarded this as intrinsically a breach of the implied obligation of good faith.

3.3. The Decision by the Specified Person

The trust deed and/or rules specify where responsibility for commutation factors lies. Gordon’s (Reference Gordon2020) finding from the thematic review was that responsibility usually lay with the trustees, this being so in 95% of cases, though other parties had a role to play:

• normally having received actuarial advice, 41%

• but certified as reasonable by the actuary, 37% (in some cases, “confirm” or “consider” was used instead of “certify”)

• subject to the sponsoring employer’s agreement, 10%

• subject to the sponsoring employer’s agreement and certified as reasonable by the actuary, 5%

• subject to the actuary’s agreement, 2%.

The actuary had responsibility in 3% of cases; the sponsor in 2%, though with the actuary certifying the factors as reasonable.

In Fisons (1992), responsibility for determining a bulk transfer value to an associated scheme was with the trustees, as advised by the actuary. This was interpreted in the lower court as the value was to be determined by the actuary and not a matter over which the trustees had any discretion. However, when the case went to the Court of Appeal Dillon LJ held that the trustees did not have to act blindly on whatever advice the actuary may give: “While, therefore, from the very nature of the problems involved they will necessarily be guided by the views of the actuaries… they will still in each case need to feel satisfied that the amount to be transferred is fair each way.”

3.4. Trustees Acting at the Specified Time

Trustees must act within the terms of their power, in relation to commutation factors, at the proper time. Pollard (Reference Pollard2020, 81.1) questions, in relation to commutation, “Why is there not an obligation on trustees to set rates only at the right time (i.e. when requested)?” This suggests, he concluded, that the right time to decide is when rates are requested (it may be more appropriate to say that it is when the trustees provide them).

Fisons (1992) involved a bulk transfer value, where the calculation had been done in March 1982 when a sale agreement for the business had been entered into, some months before the actual transfer. In the intervening period, share prices increased significantly. Dillon LJ’s conclusion was, “In the upshot, in my judgment, it might materially have affected the trustees’ decision in December 1982, if they had been properly informed as to the then current value of the fund and the implications of its value.” In other words, a material change in conditions between the calculation date and the date of the decision could not be ignored.

One potential issue is “fetters.” In Swales (1984) Nicholls J, as he then was, said, “It is trite law that trustees cannot fetter the exercise by them at a future date of a discretion possessed by them as trustees.” If the trustees’ decision has effectively been made at an earlier date owing to some fetter, that means they are not exercising their powers at the right time and considering all the relevant facts, as the relevant facts may change before the “right” time. Hence, we do not need to add to the principles in Section 3.1. Indeed, case law has established that some arrangements that might be regarded as fetters are permissible, notably if they are in the interests of the trust (Pollard, Reference Pollard2014).

As many pension schemes are large, trustees delegate decisions and establish policies rather than try to run the scheme on a day-to-day basis (Pollard, Reference Pollard2014). In the Entrust (2012a) judgement, Henderson J held that the trustees were entitled to have a general policy on applying surplus so that a decision was made on the benefits for a member leaving service at the time of leaving service rather than when he drew benefits. In the later Entrust (2012b) judgement, the same judge clarified that the trustee can lay down a policy to be followed for the future, subject to future review. It should never purport to bind itself to exercise the discretion in the future, although the policy could remain in force indefinitely “provided that the funding position of the scheme remained strong enough to justify its continued application and there were no other material changes of circumstance.”

Therefore, the important duty is to make the decision at the right time, taking into account the then relevant considerations. The implications for the frequency of reviews of commutation factors are considered in Section 8.

3.5. No Unauthorised Conflict

Briefly, fiduciaries are acting for others and not for themselves. In a non-pensions case, Bristol and West Building Society (1998), Millett LJ said that “A fiduciary is someone who has undertaken to act for or on behalf of another in a particular matter in circumstances which give rise to a relationship of trust and confidence.” In BT (2018), a pensions case, Zacaroli J described a fiduciary power as a case where “the power must be exercised for the benefit, and in the interests, of the beneficiaries as a whole.” In Edge (2000) Sir Richard Scott V-C and, later, Chadwick LJ in the Court of Appeal rejected criticism arising from trustees benefitting from decisions they made. The nature of pension schemes is such that the fiduciary requirement does not mean trustees cannot pay contributions and receive benefits like other members.

4.1. Purpose of the Pension Scheme

The proper purpose requirement limits trustees’ discretion. Millett J in Courage (1987) held, “it is trite law that a power can be exercised only for the purpose for which it is conferred and not for any extraneous or ulterior purpose.”

First, consider the purpose of a scheme itself. For a general guide, we can turn to the Pension Schemes Act 1993, which defines the purpose of a scheme as providing benefits to or in respect of people with service in employments of a description and possibly other people. Pollard (Reference Pollard2020, 14.15 & 24.2) made the point that the relevant scheme documentation must be construed to give an idea of its purpose and suggested the following as a generalisation for DB schemes: “to provide the stated and accrued relevant benefits to (and in respect of) the members at a cost acceptable to the employer.” Although some may prefer to include future as well as accrued benefits, that is contentious; and he explained the reference to acceptable cost:

“This allows room for the employer to agree an action that may incur extra cost – e.g. a benefit increase or a change in investments from ‘risky’ equities to ‘less risky’ bonds. Margaret Stone J (extra judicially) commented that the intentions underlying the creation of the trust fund ‘may also include (from the employer’s perspective) minimising the cost of the scheme’.”

As a scheme is established by an employer, its reasons for doing so could form part of the purpose, even if not set out in the rules. This may suggest the purpose is “to provide the benefits that the employer wishes to provide in a cost-effective way as part of the reward package for employees” (Cox, Reference Cox2008). The rules may reflect this by defining the benefits in accordance with the employer’s wishes, or by requiring the employer to consent to various matters.

Nevertheless, the accrued benefits provided must not be less than the benefits defined by the scheme rules and the law even if the employer wishes otherwise. Hence, part of the scheme’s purpose is to provide the stated and accrued benefits. It is right to be cost-effective in providing those benefits and some may add this to the scheme purpose, although the cost issue is perhaps more about how the scheme purpose is met rather than what the purpose is. While trustees will exercise their discretion with reference to employers’ interests, they will not be dictated by them. The purpose of the scheme will be progressed if accrual of benefits continues, but this is subject to the wishes of the employer, who will take into account whether the costs are acceptable.

I therefore suggest that the scheme’s purpose can be expressed as to provide the stated and accrued benefits and to continue to provide benefits in accordance with the employer’s wishes.

That this may not sometimes fit the rules of a particular scheme is exemplified by the High Court decision in BBC (2023) that members also have a right to future service benefits where that is within the scope of what the rules refer to as “members’ interests.” That case may be appealed.

Chadwick LJ, in Edge (2000), confirmed that it was the duty of pension trustees “to exercise their discretion for its proper purpose.” In some cases, “proper purpose” has not been followed. In Courage (1987), Millett J decided that it was contrary to the purpose of the scheme to change the principal employer, enabling the surplus to be allocated to the new principal employer instead of the surplus remaining in the scheme. In British Airways (2018), the trustees amended the scheme rules to give themselves discretion on pension increases. They then planned to give an extra amount above the increase in CPI. The employer complained and the case was decided in its favour. The Court of Appeal took the view that the trustees had moved away from their role, as explained in the scheme rules, of administering the scheme, to deciding, without employer consent, the benefit structure.

4.2. The Beneficiaries and the Role of the Employer

The Pensions Regulator’s (2007) guidance on the role of trustees includes, “You must act in the interests of the beneficiaries… A beneficiary is anyone who is entitled to, or who might receive, a benefit from the scheme, now or in the future.”

In some cases, express provision is made for the employer to be a beneficiary, for example, where the rules allow it to receive payment of a surplus. In other cases, the position is less clear; Pollard’s (Reference Pollard2006) view was that the employer should be considered a “quasi-beneficiary.” The main point, though, is that case law makes it clear that trustees must consider employers’ interests.

In Edge (2000), Chadwick LJ concluded that trustees “must, for example, always have in mind the main purpose of the scheme – to provide retirement and other benefits for employees of the participating employers. They must consider the effect that any course they consider taking will have on the financial ability of the employers to make the contributions that course of action will entail. They must be careful not to impose burdens that imperil the continuity and proper development of the employers’ business or the employment of the members who work in that business. The main purpose of the scheme is not served by putting an employer out of business.”

This was consistent with Sir Richard Scott V-C who, in the case prior to the appeal, said, “It seems to me obvious that the continued viability of the respective employers was something that, in the interests of the pension scheme and its members as a whole, the trustees were entitled to want to promote. Otherwise, if one or more of the employers went into decline or collapsed, the financial projections, on the basis of which the actuarial calculations had been made, would become invalidated.” Hence, it is relevant to consider the amount that an employer must contribute.

Asplin J agreed in Merchant Navy Ratings (2015) that it was perfectly legitimate to consider the interests of the employers, and their ability to make contributions and, as in Edge (2000), the continued viability of the employers was something the trustees were entitled to promote. She agreed that it would be incorrect to say that the interests of the employer are only relevant insofar as they benefit members. An example is the court approving plans for the employer to reduce contributions after a surplus: National Grid (2001). Further, Nugee (Reference Nugee2015) noted that while some cases had confirmed that it was right for trustees to consider the employer when allocating surplus, “it would be bizarre if they were under no such requirement when considering how to deal with deficits, where the impact on the employer’s contribution liability is that much more direct.”

It is important not to downplay the importance of members’ accrued rights. In Mettoy (1990), Warner J emphasised that members’ benefits were earned by their service and that their rights were derived from their contract of employment as well as the trust instrument. In Stevens (2002) Arden LJ held that “members of a scheme are not volunteers: the benefits which they receive under the scheme are part of the remuneration for their services and this is so whether the scheme is contributory or non-contributory. This means that they are in a different position in some respects from beneficiaries of a private trust.” Nugee (Reference Nugee2015) wrote that while trustees owe a duty to employers in the exercise of their investment powers, this would not justify trustees in using those powers to benefit the employer at the expense of the members. In Thales (2017), Warren J said that “it would require exceptional circumstance for [the trustees] to adopt an alternative index, such as CPI, in order to reduce the costs to the company if, in so doing (as in current circumstances would be the case), they would be acting to the detriment of the beneficiaries of the scheme.”

The actuary’s role was referred to in Stevens (2002), a case dealing with a surplus, some of which could be returned to the employer. Arden LJ held that the actuary was to be “fair and reasonable having regard to the interests of all concerned: members, pensioners and others, such as dependants, as well as the Employer.”

Balancing conflicting interests is important. In British Airways (2018) Morgan J held that, “I accept that the trustees had to take account of the interests of BA and of the members and pensioners of the [Airways Pension Scheme]. Insofar as those interests conflicted, the trustees had to try to hold the balance between them in a fair way.” The judges in the appeal on this case also drew attention to the need to balance the interests of the employer against those of current and former employees.

4.3. “Best Interests of Beneficiaries” or “Furthering the Purposes of the Scheme”?

A controversial case was Mineworkers (1985), where five union trustees refused to accept the fund investment plan unless it was amended to align with union policy, which would prohibit investment overseas or in oil or gas. Sir Robert Megarry V-C stated that,

However, Pollard (Reference Pollard2018a, Reference Pollard2018b) regarded a duty to base decisions on “beneficiaries’ best interests” as dangerous, imprecise, and unworkable. For example, it would literally impose a retrospective best outcome standard. In a pension scheme, it could mean requiring increased funding to improve members’ security; or using surplus to increase members’ benefits to the maximum permitted before any could be returned to the employer.

Case law demonstrates that there can be a conflict between “best interests” and the purpose of the trust. In Eclairs (2015), which is not a pensions case, the directors’ actions, while intended to benefit shareholders when corporate raiders appeared, were inconsistent with the requirement under the Companies Act 2006 that a director may only exercise powers for the purposes for which they were conferred, this being similar to the exercise of discretionary powers by trustees.

In a pensions case, ITS (2009), the trustees used assets to enhance some members’ benefits in a way that was in members’ best interests, with no member being worse off when the scheme then entered the PPF. Henderson J held that it was more important to avoid undue cost to the PPF than the trustees striving to take actions to preserve the beneficiaries’ best interests; the proposed enhancements would be invalid as being made for an improper purpose. This confirms that the “best interests” purpose is not an overriding duty: the “proper purpose test” has to be satisfied.

In Hillsdown (1991) the employer bought a company that had a scheme with a significant surplus, planning to merge it with its own scheme. The trustees negotiated an improvement in benefits in exchange for agreeing to a merger of the schemes. The trustees were held to have acted for an improper purpose when, in the absence of any power to return surplus to the employer, they intended to transfer funds to another scheme to enable the return of capital to be made. Members’ best interests were secondary to the proper purpose requirement.

Asplin J in Merchant Navy Ratings (2015) held that the best interests duty is not a paramount stand-alone duty; at best, it is merely a shorthand covering a variety of duties owed by trustees; it is part and parcel of the proper purpose principle. She went on to agree with the view of Lord Nicholls that, “to define the trustee’s obligation in terms of acting in the best interests of the beneficiaries is to do nothing more than formulate in different words a trustee’s obligation to promote the purpose for which the trust was created.” In Lonrho (2003), Patten J held that trustees were required to exercise their powers “so as to further the purposes of the Scheme as a whole, thereby bringing into consideration the legitimate interests and expectations of employee and employer alike.”

Pollard (Reference Pollard2018a) concluded that pension trustees’ duty does not relate to the interests of the beneficiaries but instead to the success of the trust or plan. They are not obliged, for example, to seek to maximise benefits or funding; instead, their duty is to seek to pay the envisaged or correct benefits. I would add that the purposes of the scheme are furthered by continuing the accrual of benefits, assuming this is in accordance with the employer’s wishes and hence at acceptable cost.

Sir Robert Megarry V-C’s “best interests” formulation would not be emphasised by a court today. I suggest it is now more appropriate to express trustees’ duties via phrases such as furthering or promoting the purposes or success of the trust or scheme (Pollard, Reference Pollard2018b).

4.4. Purpose of a Commutation Rule

I suggest it is reasonable to think of the purpose of the commutation option as enabling members to exchange some pension for cash. The purpose of discretion is to allow trustees to take into account, in determining the terms of the exchange, relevant matters such as demographic and financial conditions, and the interests of employer and members.

6.1. Actuarial Considerations: Introduction

The legal principles detailed can be applied to the issue of commutation factors. It is assumed that the scheme rules require an actuary to be involved. Cox (Reference Cox2007) has written, “Any reference to the actuary’s involvement in the matter indicates that the starting point for determining commutation factors should be the actuarial value of the pension that is being commuted”; Pollard (Reference Pollard2020, 32.2) made a similar comment. Cox added that “this would be implicit even if the actuary were not mentioned.” In Firefighters (2015), the scheme rules specified, in 2015, that the cash sum available would be the actuarial equivalent of the commuted pension (a phrase open to different interpretations); schemes are usually not so specific.

I agree that the reference to an actuary means that some actuarial value is relevant (among other matters). I suggest that this implies that commutation factors will reflect, inter alia, demographic and financial conditions, since these are fields where actuaries have expertise.

Since demographic and financial conditions can change, I suggest another implication of the scheme rules stating that an actuary is to be involved is that the commutation option factors can and indeed should (subject to other relevant considerations) change, depending on changes in those conditions. Otherwise, the actuary is redundant. Indeed, the Member Options Working Party (2006) expressed concern that some valuations assumed that current commutation factors would continue for all time, which it said may be questionable if they have not yet been adjusted to take account of (then) lower interest rates and higher longevity expectations, suggesting that changing actuarial considerations was important.

I believe this is equivalent to saying that to meet the scheme purpose, which means providing the stated benefits, the scheme has, in effect, to provide a commutation option with factors that change with demographic and financial conditions, subject to other relevant considerations. Although the change may (or may not) mean higher costs for the employer, this is different from a specific new benefit increase such as that proposed by trustees in British Airways (2018), where the courts accepted that the impact on employer costs was a reason for not agreeing to the proposal.

So, part of the member’s reward package from the employer can change. This is not a unique position as it is also true of share options, both for executives and as part of a savings scheme for employees. While we have become accustomed to both mortality rates and interest rates declining (at least until 2020 and autumn 2022 respectively), with commutation factors increasing, that isn’t always the case: note that the PPF’s factors reduced in 2006, 2009, 2018, 2021 and 2023.

Commutation factors that can change bring uncertainty for employers and scheme members. Perhaps they would prefer rules that didn’t involve discretion and specified a fixed commutation factor (or set of fixed age-dependent factors). But when factors are not fixed, one element of the exercise of discretion is to recognise the need to manage the process whereby factors are changed (see Section 8).

Several forms of actuarial calculation of the value of the pension being commuted are reviewed, which are termed “actuarial equivalence.” Four are focused on: buy-out costs (6.2), the transfer value basis (6.3), a technical provisions basis (6.4) and a transaction approach (6.5). Other possibilities are commented on in 6.6. It is considered whether the mortality, financial and expense assumptions and discount rate used by each method are relevant for the commutation process and hence the extent to which each method is a “relevant consideration.” The methods are subject to a possible addition for a guarantee charge (6.7) and/or deduction for “asset insufficiency” (6.8).

6.2. Buy-out Costs

The Member Options Working Party (2006) and the 2012 survey reported by Smith (Reference Smith2013) compared commutation factors with the annuity buy-out cost. Would trustees regard that as a relevant consideration when choosing commutation factors?

The purpose of the commutation option is to exchange pension for cash. The buy-out cost is concerned with exchanging the pension for an annuity from a life insurer. These are different. In particular, the annuity buy-out cost includes the insurer’s profit margin, reflecting, inter alia, the risks it is bearing, especially mortality and investment risks that cannot be matched. But those risks do not apply to the cash for which the pension is exchanged under commutation.

The insurer’s profit margin can also reflect the competitiveness of the annuity market, insurers’ pricing strategies and regulatory requirements (such as the introduction in 2013 of Solvency II, the regulatory regime for insurers). The annuity buy-out cost also includes the insurer’s expenses in acquiring the business and paying the pension, both irrelevant for commutation.

The Pensions Ombudsman ruled in Babcock (2014) that a trustee would not be expected to continually adjust a commutation factor to match an insurer’s annuity rate, “which is based on the insurer’s circumstances (e.g. the type of market the insurer wishes to be in, economies of scale etc.).”

Hilsden et al. (Reference Hilsden, Berriman, Crocker, Fish, Forsyth and Lindsay2023) considered the buy-out cost from an insurer but were concerned that using this would cause a funding strain and reduce the security of remaining benefits. That issue could be viewed as less concerning: the implications for funding strain should not usually affect members’ commutation benefits (see 6.5).

A practical problem is that there is no unique market buy-out cost. Insurers make different pricing decisions. Further, since the working party reported in 2006 insurers have developed individual underwriting for annuities, taking into account where retirees live, their health, etc. Trustees may not have the right to use individual underwriting but, if they did, better-paid pensioners would receive more cash (per £1 p.a. pension) than others. That is likely to lead to complaints of unfairness, contrary to pension scheme philosophy and practice, and to members’ expectations. If trustees do not use individual underwriting, they could use a buy-out cost that reflects the residence, health and other attributes of typical retirees, but that adds to operational costs.

Trustees may say that buy-out cost is a relevant consideration since it is known that annuity prices reflect mortality rates and long-term interest rates (Cannon & Tonks, Reference Cannon and Tonks2008) and these are matters affecting the value of a pension. Further, the price of an annuity may be something that retiring members are familiar with and might expect to be used. However, this paper maintains that buy-out costs are unsatisfactory for commutation factors, because of the margins included and as better alternatives are available; and, at best, are relevant only if adjusted.

6.3. Transfer Value Basis

Are the regulations on transfer values a relevant consideration for trustees deciding commutation factors? Although they do not apply to transfers within a year of normal pension age, they do reflect an actuarial calculation to exchange pension for cash.

The transfer value calculation is based on the best estimate of what is needed, if invested by the scheme, to be just sufficient to provide the benefits forgone. TPR (2008) refers to trustees being pragmatic and reasonable since “best estimate” is not a precise concept. Trustees may also use an approach that gives higher values (which is not pursued here); and the value may be reduced for underfunding (see Section 6.8).

Further, “trustees must have regard to their investment strategy when choosing assumptions. This includes the appropriate investment returns to be expected” (TPR, 2008), leading to using expected returns on the fund as the discount rate (the “expected cost” approach). Honour (Reference Honour2019) found that most respondents in a survey thought that transfer values should be based on an expected cost approach.

The transfer value regulations may have an influence in other ways. Many schemes use transfer values if a member is requesting a trivial commutation sum since they could otherwise transfer to a personal pension and then take cash. Or some members seeking early retirement may be able to access a transfer value calculated in accordance with the regulations, which could act as a benchmark for converting pension to cash in commutation.

Hilsden et al. (Reference Hilsden, Berriman, Crocker, Fish, Forsyth and Lindsay2023)’s view was that commutation rates should be reviewed in the context of providing fair value for members, and the theoretical starting point for a commutation factor should be to calculate it in line with the scheme’s transfer value basis. The rationale for this is:

• the working party could not see a good argument for anything other than broadly best estimate of the cost of the scheme providing the benefit

• it is reasonable to assume that members would typically expect to receive fair value for the pension given up, and using transfer values will ensure this

• equating transfer values and commutation factors provides consistency, given that both are methods of converting a defined benefit pension into a capital lump sum, and they may both be offered as concurrent and comparable options when a member reaches retirement.

I believe it is reasonable if trustees regard transfer values as a relevant consideration.

The thematic review did find that many actuaries considered the link to investment strategy when advising on commutation factors, suggesting that they may have used discounting at the estimated return on the fund, consistent with the transfer value approach.

Although the working party referred to members expecting to receive fair value, it did not explain what they meant by this. It could refer to the term used in accounting, although transfer values are not fair value in that sense as they depend on the composition of the assets held. Another possibility is the sense used by the Financial Conduct Authority for products under their jurisdiction, indicating that a product provides fair value where the amount paid for the product is reasonable relative to the benefits it provides. However, this is imprecise, and it is not clear why this should lead to using transfer values. Indeed, while the authors said that, “The theoretical starting point for a commutation rate should be to calculate it in line with the scheme’s cash equivalent transfer value (“CETV”) basis,” if the theory underlying this is that it should be the best estimate cost to the scheme of the pension given up, this paper proposes that the theory should not go unchallenged.

I suggest that trustees thinking of using the transfer value approach for commutation factors may be concerned about using a discount rate that depends on the scheme’s investments. One issue is that there is scope for significantly different views on the estimated return on investments. More fundamentally, though, members may be unhappy if trustees take increased investment risks and their cash sums reduce. Further, and of greater relevance, employers may have concerns that de-risking increases commutation factors and, therefore, the contributions required. Indeed, why should members’ benefits depend on the investment choices of the trustees, which may reflect a variety of considerations? Cox (Reference Cox2007) commented that a change in investment strategy should not affect the commutation benefits. Indeed, consider an unfunded scheme. A member’s commutation rights need to be valued but you can’t use the expected return on the fund assets as there aren’t any.

Indeed, the question of what discount rate to use for transfer values has been debated, and the Actuarial Profession, in its “Response to DWP consultation document: Approaches to the calculation of transfer values” (2006) said that, rather than the expected cost to the scheme of providing the benefits (discounting at the expected rate of return on the fund), “the better actuarial view” was to consider “value to the member” (discounting at bond yields). An explanation of why this is can be found in Cowling et al.’s (Reference Cowling, Frankland, Halls, Kemp, Loseby, Orr and Smith2012) paper, which concluded that a transfer was a transaction between scheme and member that should be completed using market-consistent terms. This, they argued, required a “matching framework” where the discount rate was the return on the assets that matched the benefits being given up, regarded as gilts, independent of the assets actually held by the scheme.

Implementing the view of the Actuarial Profession in its 2006 response to the consultation would have led to increases in transfer values compared with the previous practice of using the expected cost (as in regulations then set by the profession). The concerns raised led to regulation of transfer values being taken over by the government. In deciding what to do, the government’s objectives were: to be fair to transferring and other scheme members and to scheme sponsors; to not weaken or impact the scheme funding position; and to be broadly neutral in their impact on transfer values across all schemes (DWP, 2008).

Given these objectives, it is not surprising that the government decided (DWP, 2008) that it could not accept the profession’s proposal, as this would increase transfer values, be inconsistent with the funding arrangements, and lead to higher costs for business and the taxpayer (there were also concerns about a complex approach to the employer covenant). Hence, existing practice was largely retained, typically involving a discount rate where equity yields played a significant part.

Hence, the transfer value regulations largely reflect a desire to keep to the regulations previously set by the actuarial profession even if it was not, in 2006, recognised as “the better actuarial view.”

The issue with commutation factors is that they are not regulated, and a variety of practices pertains. I suggest that the rationale for the current transfer value regulations does not give guidance on what is most appropriate for commutation factors.

It is understandable if trustees regard the transfer value basis as a relevant consideration. It is laid down in regulation for converting pensions into cash; and trustees may not want a commutation basis that gives different results. This may be especially true if a member is commuting for a trivial lump sum or taking early retirement benefits. However, this paper takes the view that using the transfer value basis gives rise to some unsatisfactory consequences because it uses a discount rate that depends on the composition of the scheme’s assets.

6.4. Technical Provisions Basis

Could trustees use, or regard as a relevant consideration for commutation factors, the assumptions underlying the technical provisions in the regular valuation for trustees? This may be thought suitable as paying a cash sum derived from the assumptions underlying the technical provisions would leave unchanged the surplus or deficit (calculated using technical provisions).

Technical provisions have to be calculated prudently, and prudent margins will inflate technical provisions. It would seem unfair to inflate commutation factors as a result (similar to why technical provisions are not used for transfer values). Further, the discount rate chosen is usually a prudent estimate of the expected return on the scheme assets, which is a concern to those who believe that commutation factors should use a rate independent of the scheme assets (see 6.3). Another issue is that the discount rate may be chosen to smooth the funding ratio or the contributions payable by the employer; and is subject to change as regulations change. It may not, therefore, be appropriate for the separate purpose of determining member benefits on commutation.

I can understand trustees regarding the technical provisions basis as a relevant consideration: they may wish to take into account the implications of the commutation factors chosen for the technical provisions and hence the funding ratio, even if it is regarded as an imperfect reflection of the strength of the scheme. Nevertheless, I conclude that the technical provisions basis is unsatisfactory for commutation factors.

6.5. A Transaction Approach

Commutation is a transaction between the scheme and the member. It is a take-it-or-leave-it transaction, with the member having limited information with which to judge whether the terms are fair. The transaction approach suggested here instead asks what the price is at which that transaction would take place if carried out in an orderly way between willing parties, without either party having material advantages in terms of information or market power. This looks to avoid what might be described as unfairness or artificiality arising from the trustees or employer having greater information and/or market power than members. I believe that this is consistent with the need for fairness that the legal principles require.

In seeking such a price, I draw on Cowling et al. (Reference Cowling, Frankland, Halls, Kemp, Loseby, Orr and Smith2012), whose view was that where an actuarial calculation relates to a transaction (commutation being an example), the outcome should be market-consistent value, which is the price that would be determined in an orderly market. It uses a discount rate that is the yield on the assets that match the liability. This was the case whether the fund held those assets or not; the authors’ view was that such assets are gilts. Such a method can be applied to unfunded as well as funded schemes.

This is the “value to the member” approach as in the discussion on transfer values (Section 6.3) where it was accepted as “the better actuarial view.” I believe that is the case here too. The member is giving up some pension and we should assess what the value is to the member of what is being given up. The expected cost to the scheme, discounting at the return on fund assets is a different matter, depending on the investment strategy that trustees decide in conjunction with the employer.

Cowling et al. (Reference Cowling, Frankland, Halls, Kemp, Loseby, Orr and Smith2012) felt that using market-consistent value was particularly important in transactions where objectivity and fairness between the parties was paramount. I believe that is the case here: it is a relevant consideration for trustees as it reflects the requirements for fairness and for the decision to be based on demographic and financial conditions at the relevant time. This is, however, subject to concerns about practicality.

I suggest the mortality rates appropriate for this basis are the rates that are expected to apply, taking into account future changes. I believe this is best expressed as probability-weighted means, which is an accepted practice under accounting standards (International Accounting Standards Board, 2018, 6.93(a)) and preferable to a “best estimate” which, while consistent with accounting standard IAS 19, lacks clarity (mode, median or mean?). I would not expect trustees to attempt to consider mortality using individual underwriting (see Section 6.2).

To be impartial, what is relevant is the mortality of members who commute, who may have a lower life expectancy than other members, justifying lower commutation factors than otherwise. There is, at present, no specific evidence on this, and the fact that most members do commute suggests that any selection effect is quite modest. Hilsden et al. (Reference Hilsden, Berriman, Crocker, Fish, Forsyth and Lindsay2023) warned of the dangers of using some implicit assumption about selection not informed by evidence.

Turning to financial assumptions, commutation factors will reflect both inflation in the pension being exchanged and discount rates (“discount rate” is used as shorthand for a series of discount rates by term).

What would the courts expect trustees to do? In Mettoy (1990), Warner J held that, “It was common ground that the relevant background facts or surrounding circumstances included common practice from time to time in the field of pension schemes, as evinced in particular by the evidence of the actuaries and by textbooks written by practitioners in the field.”

The following actuarial papers suggest that bond yields provide the appropriate discount rate for commutation:

• Cowling et al. (Reference Cowling, Frankland, Halls, Kemp, Loseby, Orr and Smith2012) recommended a discount rate that is the return on assets matching the pension liability, i.e. bonds

• the Member Options Working Party (2006) referred to long-dated interest rates having fallen substantially

• the Actuarial Profession’s letters in 2007 to the DWP and TPR referred to changes in market conditions such as long-dated interest rates

• life insurers typically price annuities with reference to bond yields (Telford et al., Reference Telford2011).

Recall that the liability calculations for the Minimum Funding Requirement (MFR) required pensions in payment to be valued using yields on gilts (inflation-linked if applicable), again supporting bond yields for commutation as we need to consider only pensions about to be paid. Valuing other liabilities in MFR calculations used, inter alia, equity yields, but that is irrelevant for the subject of commutation factors as we are not concerned with discount rates for the current accrual of pensions.

For example, the PPF is required to use actuarial equivalence, and has the principle that the discount rate should be a risk-free rate, which is taken as 75% of the gilt yield and 25% of the yield on a mixture of interest rate swaps less 15 basis points (PPF, 2019). Another instance is the pension scheme in Firefighters (2015) where the Government Actuary’s Department referred to using interest rates in determining commutation factors, in 2015.

One paper, Hilsden et al. (Reference Hilsden, Berriman, Crocker, Fish, Forsyth and Lindsay2023), has a different approach, favouring discounting at the return on the fund assets as a whole, which may include equities. We have also seen (Section 6.3) that many actuaries link their advice with investment strategy, which can lead to the return on equities being included. If, however, a scheme has a specific investment strategy to invest in bonds for pensions in payment, it would arguably be logical to use the yield on bonds.

The thematic review identified many considerations used in advising on commutation factors, and Warner J might be disappointed by the absence of a clear view expressed in textbooks/papers or practice.

Clearly, bonds bear some credit risk, so their yield reflects both the time value of money and the default risk. For commutation factors, the time value of money is relevant together with the risks around the pension that is being exchanged: it is not clear at what level it will be paid (depending on inflation) and whether it will be paid at all (the scheme may fail to pay). The time value of money is represented by the yield on a risk-free bond: this could be the yield on UK government bonds (inflation-linked bonds where the pension inflates).

The calculations are not necessarily straightforward. Relevant issues can include the following, and addressing them may produce a variety of approaches:

• there not being gilts or other assets with cash flows that match the liabilities completely, aside from mortality.

• the use that can be made of yields on swaps or corporate bonds, or higher-yielding assets, with adjustment for credit risk (the Solvency II regime for insurance companies uses swap yields with an adjustment for credit risk).

• the need to consider minimum and maximum rates of increase applied to pensions.

• the possibility of reflecting the illiquidity of pension liabilities in a discount rate that reflects yields on illiquid assets, i.e. including an “illiquidity premium,” although quantifying such premium can be difficult.

The additional risk - that the fund has insufficient assets to pay the pension – involves consideration of the employer covenant, and is dealt with separately (Section 6.8).

Hence, I believe that, in this transaction approach, a suitable starting point for the discount rate can be the yield on gilts (index-linked where applicable). Reference may also be made to swaps or other investments but modifying for credit risk. Some other adjustment may also be justified, noting that gilts are much more liquid than pension liabilities. The outcome may therefore be a little above gilt yields.

If gilt yields rise, the commutation factor decreases. Is this fair to a new retiree? If the cash was invested in a long-term gilt, the reduction in cash is balanced by the higher interest. Of course, some will use the cash to clear a debt, others will spend it shortly after retirement, others will invest in different ways. Some investors may choose assets they think have a higher expected return, such as equities: could trustees use that higher return to justify a lower commutation factor? I say no: if using a bond discount rate produces a cash sum of £1000, the retiree would reject an argument (surely spurious) that that this is equivalent to £800 in equities and would still expect £1000 to use as they wish. I suggest that the trustees would not regard as a relevant consideration, in deciding commutation factors, either an individual’s plans for spending or investing their cash; or, to be applied to all retirees, a discount rate based on some assumption about the higher returns available, at some risk, from investments that some retirees may choose.

To be fair between members who commute and those who do not, the trustees need to consider the expenses of operating the commutation facility, if these are paid from the fund. Alternatively, expenses could reasonably be ignored if they are not material.

Hilsden et al. (Reference Hilsden, Berriman, Crocker, Fish, Forsyth and Lindsay2023) have a different view on the discount rate. Calculating commutation factors using a “gilts flat” basis (which could mean a little above gilt yields) would not, they said, seem appropriate because this would lead to a funding strain and lower security for the remaining benefits.

My perspective on this is:

• the trustees should set commutation factors that are based on relevant considerations with a fair outcome. If that leads to payments to members causing a funding strain, it is up to the employer to fund the scheme so that benefits are secured. The implications for employers’ contributions may be such as to make it fair to reduce commutation factors, but I believe that the circumstances where this is appropriate are restricted (see Section 7.2)

• this means that whether there is a funding strain is not necessarily relevant to commutation factors. Nevertheless, if the scheme is 100% funded on a valuation basis that discounts liabilities using gilts (or similar) yields, no strain arises; and the valuation may already take into account factors being determined using gilt (or similar) yields

• if the scheme is less than 100% funded, then some reduction in commutation factors may be justified, although Section 6.8 suggests that a deduction on these grounds would often not be appropriate.

Hilsden et al. (Reference Hilsden, Berriman, Crocker, Fish, Forsyth and Lindsay2023) did suggest that if the scheme was close to full buy-in/out it might be appropriate to advise on aligning commutation factors and insurer terms. They say that the latter are generally market-related; but they are also generally based on bond yields. They add that how close a scheme is to buy-in/out may involve some judgement. I suggest that using a discount rate that is independent of the composition of the scheme assets would be more objective.

A relevant consideration would be a transaction approach to actuarial equivalence, using a discount rate and assumptions for mortality and future inflation as with a market-consistent value of the pension being exchanged; and expenses in connection with commutation, if met from the fund, unless they can reasonably be ignored.

The transaction approach is not entirely satisfactory, however. The transfer value approach could produce greater consistency if a member is commuting for a trivial lump sum or taking early retirement benefits.

6.6. Review

Of the approaches discussed, I expect that using buy-out costs gives the highest commutation factors (primarily due to including insurers’ margins); next is the transaction approach; then the technical provisions basis (the discount rate is higher than the risk-free yield on the transaction approach, but partially offset by the inclusion of prudent margins); lowest is the transfer value basis (as for technical provisions but without prudent margins).

Other actuarial calculations are possible. For example, trustees could decide that while they do not wish to use the composition of the scheme assets in determining the discount rate, they prefer the expected rate of return on some portfolio that includes equities as well as bonds. Or they could use the set of actuarial assumptions used by the firm in valuing its pension liabilities in its statutory accounts: in practice, this would be close to the transaction approach except for discounting at a corporate bond yield rather than a risk-free yield.

There may be concerns about using market rates for financial conditions. Would it be satisfactory in September 2022 to use gilt yields that had risen sharply after the government’s Budget? At other times one could say that interest rates were unusually low, affected by quantitative easing and the limited supply of index-linked gilts. Trustees may believe that current conditions reflect some temporary “blip.” One response could be to use some assumed future or “smoothed” interest rate if the trustees believe that is relevant. That may also avoid frequent changes in commutation factors, although I suggest that would not ordinarily be a main objective of the trustees (rates do vary: see Section 8).

I believe that a transaction approach is, overall, more satisfactory than the alternatives discussed in Sections 6.2–6.4. Some may say the transfer value basis is appropriate, having been set by government in a context of converting pension to cash (transfer values). Recall that the Actuarial Profession (2006), when writing on transfer values, had argued that “the better actuarial view” was “value to the member.” It said that its primary concern was what was fair to the member, and it was for the government to consider wider issues. As discussed in Section 6.4, the government’s concern was to preserve consistency with previous regulations on transfer values. When dealing with commutation factors, which are not currently regulated and where practice varies, that rationale does not appear applicable.

Trustees could regard any or all of the four approaches discussed as relevant considerations; the weight given to each is their decision. This is subject only to the need for the trustees’ choice not to be one that no reasonable set of trustees would make.

The further elements of actuarial equivalence are a guarantee charge (Section 6.7) and a deduction for asset insufficiency (Section 6.8).

6.7. Guarantee Charge

When trustees respond to an enquiry from a member, shortly before retirement, about the benefits to be received, they may wish to guarantee that the commutation factor advised will apply at the retirement date. This helps the member plan and avoids the costs of a later re-calculation. Hilsden et al. (Reference Hilsden, Berriman, Crocker, Fish, Forsyth and Lindsay2023) suggested this might be 3 months where factors were reviewed frequently.

If so, commutation factors can be adjusted to charge for the guarantee, the main issue being the volatility of long-term interest rates. However, it may be reasonable not to make a charge if it was felt to be immaterial. Determining the guarantee charge is outside the scope of this paper (an option pricing approach could be used).

Difficulties may arise, whether or not a guarantee charge is included, taking into account that two members retiring on the same date can request a quotation at different times and that financial conditions can change. Both practicalities and the need for fairness will be relevant in making a decision about guarantees and a charge.

6.8. A Deduction for “Asset Insufficiency”

Commutation factors can allow for the possibility that the pension exchanged will not be paid because the fund assets are insufficient. Assessing the likelihood of that is difficult, depending on future conditions and decisions as well as the current strength of the fund. A stochastic model could be used (see Turnbull, Reference Turnbull2014); a short-cut method could look at the scheme’s risk-based levy to the PPF.

Another possibility is to use the process for transfer values, where regulations allow these to be reduced below “best estimate” values by the percentage shortfall in an “insufficiency report,” which compares the fund assets with liabilities. Here, the liabilities are calculated using “best estimates” of mortality and the returns on the fund, and not the technical provisions, which may have prudent margins. However, TPR (2008) indicates that, where the covenant is judged to be strong, and any deficit is being remedied over a reasonably short period, the trustees should not normally reduce transfer values. The trustees should also consider the degree of underfunding, and any contingent assets that are available. Hence, it is not surprising to find that most schemes that could pay reduced transfer values do not do so in practice (Honour, Reference Honour2019).

A similar approach could be used for commutation factors with the actuary consulting the trustees about whether the covenant and so on made an “asset insufficiency” deduction appropriate. The transfer value methodology may be adjusted; there are alternative ways of estimating “realistic” liabilities. Hilsden et al. (Reference Hilsden, Berriman, Crocker, Fish, Forsyth and Lindsay2023) also argued that if a scheme was particularly underfunded it may be appropriate to reduce commutation factors, noting that transfer values can be adjusted in those circumstances.

In practice, the potential for reducing commutation factors may be quite limited. This is because the insufficiency report recognises the prioritised needs of different groups, where the level of compensation payable to members under the PPF is important. A retiree’s pension may be no more than the PPF compensation that would be received. Hence, in many cases, this asset insufficiency adjustment would have little or no effect. Further, trustees may regard it as unfair to reduce commutation factors if transfer values were not also being adjusted. Making the adjustment may also be complex, given that assets and liabilities are always changing.

A different conclusion may be that, for example, a 70% funding ratio justifies a 30% reduction in commutation factors. My view is that this does not properly recognise the security of the pension rights of a member on the point of retirement.

7.1. Expectations and Wishes

Beyond actuarial equivalence trustees may incorporate additional considerations. Can their discretion reflect the expectations of employers and members? In National Trust (1998) Robert Walker J was “inclined to think that legitimate expectation may have some part to play in trust law.” Looking at pensions cases, in Merchant Navy Ratings (2015) Lord Nicholls said: “it was necessary first to decide what is the purpose of the trust and what benefits were intended to be received by the beneficiaries.” In Lonrho (2003), Patten J said that it was for the trustee to bring into consideration the legitimate interests and expectations of employee and employer alike.

The expectations of members are not easy to determine, as this is a subject on which they have generally have limited knowledge (and perhaps little interest until shortly before they retire). Members might assume they are entitled to 100% of actuarial equivalence, but there is unlikely to be documentary support for this. Indeed, the fact that 12 is the usual commutation factor in public sector pension schemes explodes any argument that 100% (or around 100%) of actuarial equivalence is universal or necessary. Past practice, even if poorly understood can, however, influence expectations.

Expectations are not, of course, decisive. In IBM (2017), a case concerning cessation of accrual, Warren J held that members’ expectations were no more than a relevant factor that the decision-maker can, and where appropriate should, take into account. Expectations could, he said, be affected by changes in financial circumstances.

As regards expectations of employers, consider an employee joining a scheme. The accrual rate has been set, and the employer could decide that, for this new accrual, a fixed (or maximum) commutation factor should apply. If, however, the employer accepts that factors are to be determined by trustees on actuarial advice, and they currently use factors that are, say, 90% of actuarial equivalence (on some particular basis), it appears reasonable to assume that this reflects the employer’s wishes and expectations. Indeed, if it wasn’t, the employer could express its wish that factors were, say, 80% of actuarial equivalence rather than 90%.

Since one purpose of the scheme is to continue to provide benefits in accordance with the employer’s wishes, those wishes are a relevant consideration: indeed, an important consideration. The employer’s wishes are usually its expectation, although it needs to check that the law and scheme rules permit its wishes to be accommodated. If the trustees insist on using 90% when the employer wishes to use 80%, the employer could, in principle, close the scheme to future accrual (assuming that this does not breach the Imperial duty of good faith). The trustees may then feel able to continue with the 90% proportion that applied for accrual when the scheme was open. A different outcome could be the employer insisting on changing the scheme rules to specify an 80% proportion or a fixed factor that gives about the same result. I suggest that it would apply only to future service; otherwise, would the employer be reducing a benefit for past service?

Given the concerns about trustees’ discretion that this paper raises, I believe that if the discretion can be replaced by a formula (x% of actuarial equivalence) or specific factors being defined in the rules, that could be beneficial. Employers still have an incentive to set factors that are not “too low” since that would reduce the number of members taking cash and increase the cost of the scheme. However, this approach is of limited value as it would not affect schemes that are already closed.

In principle, if the employer’s wishes for commutation factors change, say from 90% to 80% and then 70% of actuarial equivalence, and if trustees set factors accordingly or they are reflected in the rules, a member might retire with some accrued pension having a commutation option with 90% of actuarial equivalence, some with 80%, some with 70%. I call this approach the “benchmark expectations” approach. This is not, of course, the way that DB schemes have operated, and I do not think it practical to apply it now, although I believe it is a useful perspective to consider.

An employer may say it expects any new factors to apply to both past and future accrual, and trustees may regard this expectation as a relevant consideration. I regard this as unsatisfactory. Surely, the original commutation factors reflected the employer’s wishes, intention and expectation at that stage. Further, if members have expectations from past practice and the demographic and financial conditions that have applied (in the sense of x% of actuarial equivalence), they have no protection if the commutation factor is suddenly reduced just before retirement without reference to demographic and financial conditions. The Imperial duty of good faith could be an issue here, as well as whether it can be argued that an accrued (commutation) benefit is being reduced.

When looking to ascertain what factors have been in the past, it is noted that up to 2006 trustees’ decisions were restricted by the Inland Revenue (2001), and maximum commutation factors were below 100% of actuarial equivalence, at least using either the transaction or buy-out cost basis. The maximum factor for a male retiring at 65 and receiving a level pension was 9. This was equivalent to an annuity valued using UK Interim Mortality Tables 1998-2000 (without future improvements, as was then typical practice of pension actuaries) and discounted at 6.7% p.a., above gilt yields at the time (about 5%). For pensions inflating at a fixed rate the discount rate had to be at least 8%; if inflating at above 5% but limited by the RPI then a “real” discount rate of at least 3% was to apply (inflation-linked gilts yielded 2%-2.5%). The Inland Revenue also constrained factors in earlier years. This suggests that a scheme with factors below 100% of actuarial equivalence may justify that as being consistent with past practice, although precise calculations depend on, for example, what illiquidity premium is used.

Potentially relevant are changes in 2006 in the scheme rules and/or the role of the actuary, who had perhaps been satisfied with Inland Revenue maximum factors in a wide range of circumstances. Practice in some schemes has changed, in some cases to around 100% of actuarial equivalence, others (with limited updating for changes in demographic and financial conditions) to below 50%.

A range of ways of determining expectations is available to trustees. I believe it is useful to consider the benchmark approach to expectations. I suggest it reflects what the employer has, implicitly, intended over time. It also ensures that members’ rights are consistent with past practice and with changes in demographic and financial conditions. It means that an employer’s new wishes can be applied for future accrual while protecting the past expectations of members. While not an approach that is now practical to implement, I believe that trustees can benefit from thinking through what it involves in order to take a view on what expectations should be given weight as a relevant consideration.

7.2. Implications for Employers’ Contributions

The effect of commutation factors on employers’ contributions is certainly something for trustees to consider.

Reflecting employers’ concerns about the cost to them of commutation factors, trustees may take into account the following potentially relevant considerations:

1. (a) The purpose of the scheme, it can be said, is to provide benefits at a cost acceptable to the employer, who may say that the contributions are unacceptable (perhaps in the context of other developments that are affecting the business), hence the benefits should be adjusted.

2. (b) The employer’s original purpose of the scheme may have been to provide benefits on the basis that it could discontinue the scheme (for example if pension costs had increased, leading to a deficit), so that the benefits were not fully legal liabilities (this position being changed in 2003); the employer may argue that this justifies a stance that the trustees should respect its intention not to be subject to mortality and financial risks that increase commutation costs.

3. (c) The employer may argue that it is the significant or unexpected nature of the demographic and/or financial changes that means that the higher contributions are unacceptable, especially if they were not budgeted.

4. (d) Some schemes have taken investment risks which, when beneficial, have been used to increase members’ benefits; it is therefore arguable that adverse investment outcomes could reasonably impact members’ benefits.

5. (e) The employer may regard higher contributions as unacceptable because of the potential that the firm will be weakened and the scheme’s ability to pay the stated benefits will be threatened.

6. (f) The consequence of higher contributions may be the employer reducing jobs or wages or worsening working conditions. Members may also be disadvantaged for other reasons, such as the sustainable growth of the employer being affected (TPR has a statutory objective to minimise such impacts) or because the business is put at higher risk, with the potential for adverse effects on wages etc. in the future. These may not strictly detract from the scheme purpose. Note, though, Arden LJ’s remarks in Stevens (2002): “the relationship of members to the employer must be seen as running in parallel with their employment relationship. This factor, too, can in appropriate circumstances influence the interpretation of the scheme.” Hence, trustees should consider such potential outcomes as relevant, although it can be tricky to take into account differing interests of retiring members, who are not subject to cuts in wages, etc., whereas other members are (and non-member employees are also potentially affected).

Now it is surely the case that an employer with a scheme open to future accrual, and keen to reduce its costs, could express a wish to restrict commutation factors for future accrual. This is naturally subject to the provisions of the scheme rules and the Imperial duty of good faith. Such a wish is clearly something for trustees to consider; and indeed is an important consideration, especially if the scheme rules could be altered to formalise that restriction.

The employer may also suggest that the contributions it makes are a relevant consideration for commutation factors for the past accrual of benefits. However, potentially relevant considerations can be put forward to emphasise the importance of scheme members’ rights:

1. (g) The obligation to pay accrued pension benefits continues even if the employer regards the costs as unacceptable, and it can be argued that expectations of commutation factors in relation to accrued pension benefits should be similarly protected, even if they are not strictly accrued benefits in accordance with Section 67 of the Pensions Act 1993. This takes into account that members’ benefits are derived from their employment and form part of their reward package, and are unlike discretionary benefits under a family trust (see Mettoy (1990) and Stevens (2002): Section 4.2);

2. (h) It is wrong for trustees to now acknowledge some benefit for employers from the ability they originally had to discontinue a scheme, without the benefits being fully legal liabilities because that right was ended in 2003, having been felt to be unfair to scheme members; and if employers did not then reduce their exposure to demographic and financial risks (by, for example, insurance, hedging and asset-liability matching) that implies they were willing to bear those risks

3. (i) This is a DB scheme, under which:

   • the employer chose to have variable, not fixed, commutation factors

   • with variable factors, the role of the actuary implies that, subject to other relevant considerations, commutation factors should reflect changes in demographic and financial conditions

   • the employer was exposed to uncertain costs; it could have chosen to mitigate the demographic and financial risks involved. Where investment risks remained and turned out successfully, the employer may have benefitted from lower contributions

   • if costs increase to a level the employer then regards as unacceptable, that reflects its choices about bearing risk

4. (j) While members’ accrued rights may have been increased when risks turn out well (although it is typically many years since this has happened), accrued rights may not be reduced when risks turn out badly, and arguably the same applies to expected commutation factors in relation to accrued pensions.

My view is that the arguments in (g), (h), (i) and (j) negate those in (a), (b), (c) and (d) respectively. Trustees may, of course, disagree.

However, I believe that (e) and (f) are relevant considerations: if it is expected that members would be worse off because of the higher contributions (including there being a reasonable likelihood of being worse off), it would be sensible to adjust commutation benefits. There is a caveat: Pollard’s (Reference Pollard2006) comment that the employer “will be mindful of not making a threat that could breach the [Imperial Group] implied mutual duty of trust and confidence” is relevant here.

It is difficult for trustees to assess if they expect members to be worse off, and there can be tricky issues for differing categories of members. In practice, it is for trustees’ judgement rather than objective calculation. Trustees may take the view that, in these circumstances, they would not increase factors if that was expected, owing to new demographic and financial conditions (avoiding a reduction, which could produce a greater conflict with members’ expectations).

One other relevant consideration should be mentioned. Employers’ contributions attract tax relief which means the employer’s wish to pay benefits in a cost-efficient way is not helped by restricting commutation benefits, as the cash is tax-free to members (7.3).

Of course, trustees may come to a variety of conclusions about the relevance of the effect on the employer’s contributions.

7.3. Tax

The lump sum being tax-free is a product of history, as recognised by the report of the Millard Tucker Committee (1954), which supported their remaining tax-free (with an exception for trivial commutation). The government did not accept their recommendation that approved schemes should not provide tax-free cash of over £10,000 (equivalent to £209,000 in 2022 using the Bank of England inflation calculator). Views about the tax-free status of cash continue to differ (see Adam et al., Reference Adam, Delestre, Emmerson and Sturrock2023).

Should commutation factors be reduced because the cash is tax-free? McLeod (Reference McLeod2005) asked why the employee, and not the employer, should enjoy the tax concession, and mentioned the withdrawal of tax relief on equity dividends in pension schemes in 1997, which increased employer costs. Pollard (Reference Pollard2020, 46.39) included tax as possibly a relevant factor; the thematic review report suggested that some actuaries may have taken it into account (Gordon, Reference Gordon2020).

Could commutation factors reflect each individual’s tax rate, so that a member with a high marginal tax rate would be given a lower factor? There are practical issues such as whether the relevant tax rate relates to income excluding or including the cash sum and, if the latter, is it assumed to be spread over several years? Income tax rates differ between Scotland and England: is that relevant to trustees’ discretion? Problems would also arise if a nil tax rate band applied. I suggest that the trustees should not regard individuals’ tax rates as relevant, given that this is not mentioned in scheme rules, is not consistent with pension scheme past practice and philosophy and raises serious practical problems.

Some may argue that commutation factors should be reduced by the basic tax rate because the cash is tax-free. However, this still raises issues of fairness for individuals with a nil or lower tax rate; and some would query the tax-free cash being an advantage only for higher rate taxpayers. Similar concerns apply to other suggestions for reducing factors because the cash is tax-free.

Further, it may be that reducing commutation factors for tax reasons is contrary to public policy. HM Treasury (2015) has said that the tax-free lump sum is an incentive for people to save more. In DC schemes the employee benefits. In DB schemes it provides an incentive to join in the first place (although not now relevant for closed schemes). I suggest that this implies that the government thinks members, rather than employers, should benefit from the lump sum being tax-free.

In ITS (2009) the need to preserve the public interest led to the court ruling that trustees’ actions were not acceptable in view of the implications for the PPF. A similar point can be made here if we deduce that public policy favours members, not employers, benefitting from the tax break.

Members may well recognise that the lump sum they receive is tax-free: this status is long-established and referred to in the press periodically. Some trustees mention it in scheme literature. This is, of course, true whether members or employers receive the benefit of the tax break. However, some members might be surprised if trustees then allocate the tax break to the employer so that they do not actually gain.

Hilsden et al. (Reference Hilsden, Berriman, Crocker, Fish, Forsyth and Lindsay2023) did not regard the tax break as relevant for commutation factors. This was because a member’s tax status is an individual matter; and the lump sum is usually described to members as being tax-free.

Trustees may regard the tax break as a relevant consideration, but I do not regard that as satisfactory if it leads to restricting commutation factors to benefit the employer. This takes into account that government tax policy is designed to encourage saving, potential issues of unfairness, the inconsistency with DC arrangements, and the expectation of some members that they will gain after being told the cash is tax-free.

Indeed, both employer and scheme members could gain from the tax-free status if trustees chose higher rather than lower commutation factors. If we think of the purpose of the scheme as enabling an employer to provide benefits in a cost-effective way as part of a reward package (Section 4.1) then we take into account that the employer receives tax relief on both salary payments and pension contributions, whereas employees pay tax on salary but not on cash sums (within limits). Higher cash sums, indeed possibly with lower salary, offer a net benefit. It is, of course, His Majesty’s Revenue and Customs that loses.

This exemplifies again that trustees’ discretion in choosing the relevant considerations and applying them may lead to quite different outcomes for employees in their reward package.

7.4. Utility

Trustees may decide to offer cash, the utility of which matches the utility of £1 p.a. pension. They may say this is, say, £18 if that is what, in practice, members have chosen in commutation. Cash provides flexibility and liquidity, enabling members to spend, invest or repay debt as desired instead of the level or inflating pattern of a pension (although they are losing the pension guarantee). This can lead to factors below actuarial equivalence.

I suggest that viewing commutation in this light is rather different from viewing it as a transaction carried out on a well-functioning market, which I believe is more appropriate:

• members may be inadequately informed to make a decision. People tend to underestimate how long they are likely to live; this pessimism may mean they do not buy annuities (O’Dea & Sturrock, Reference O’Dea and Sturrock2020) and may value cash unduly highly in comparison. They may also have inadequate financial ability to appreciate the impact of discounting, especially over a period that may exceed 20 years.

• trustees are taking advantage of an effective monopoly. If it was practical for members to exchange pension for cash with a financial institution (mortality risk is an obstacle, of course), it would be at market rates, i.e. around actuarial equivalence, but with charges to cover expenses and risk, and make a profit. Since other institutions cannot, in practice, offer commutation, it enables pension trustees to offer terms that are unfavourable (especially so when we consider that they do not have the same credit risk or expenses).

In practice, it would be difficult to estimate utility factors, as past practice under different financial conditions would not be relevant, and factors would differ between members.

Trustees’ views may differ - I believe that using the “utility” argument is unsatisfactory.

7.5. Optionality

The thematic review suggested that some actuaries have taken into account that commutation is only an option; a member who judges that the terms are unsatisfactory can just take the full pension. In Nissan (2019), the trustees took into account that commutation was a personal decision for individual members; the Pensions Ombudsman agreed that it was relevant and rejected a complaint about a factor of 11.73 (the member’s age was not stated).

I have concerns about the use of the optionality argument to justify lower factors than would otherwise apply. First, while a member could take all benefits as pension, this is less advantageous with regards to tax, and also the liquidity and flexibility that cash provides. Second, how can the optionality principle guide trustees other than suggesting lower factors are more appropriate than higher factors? I question whether trustees doing so would be using their discretion for the purpose of reducing employer contributions rather than furthering the progress of the scheme (the proper purpose requirement).

Further, Hilsden et al. (Reference Hilsden, Berriman, Crocker, Fish, Forsyth and Lindsay2023) did not believe that the optionality (or otherwise) of the commutation benefit was relevant to setting commutation factors, given how commonly members opt for this benefit.

Incidentally, the trustees’ relevant considerations in Nissan (2019) included, as well as members’ interests and the scheme funding position, the planned re-design of the plan. It is not clear to me why such a re-design affects the terms for exchanging pension for cash; and if it does, why are the factors not reviewed when the re-design is introduced?

7.6. Market Practice

In Edge (2000), Chadwick J held that the trustees must consider benefits relative to benefits under comparable schemes or the pensions market generally. It was argued that the main purpose of the scheme is not served by contributions and benefits that deter employees from joining. This argument is less relevant to schemes that are already closed.

The variety of commutation factors used indicates that there is no clear “market practice.” A response to a complaint about low factors might be that other schemes had low factors, although the complainant could then draw attention to comments such as “pensioners may be short-changed.”

I also agree with Hilsden et al.’s (Reference Hilsden, Berriman, Crocker, Fish, Forsyth and Lindsay2023) concern that there are dangers in using benchmarking data because of risks such as herding and group thinking.

Hence, while trustees may consider market practice as potentially relevant, I think it is unlikely to play a part in most trustees’ decisions in a satisfactory way.