Commutation: key actions for fair value

I had a blast from the past last week when I saw a commutation rate of £9 written into the rules of a scheme I had recently taken on. The scheme rules were first written in the 1980s and although it wouldn’t have been an unusual commutation rate then, it certainly hadn’t stood the test of time.

Even where commutation rates are routinely reviewed and updated, research shows that members may be receiving poor value because trustees are typically using commutation rates that are much lower than the scheme’s cash equivalent transfer value factors. Research published by the Actuarial Monitoring Scheme (AMS) revealed that of the schemes reviewed as part of the research, a median transfer value at age 65 of £29 for £1 pa of pension was used and a median commutation rate at the same age was £18. Even allowing for differences in partner pensions (which commutation rates tend to exclude, but cash equivalent transfer factors include), there is still a significant difference between the two factors.

The role of actuaries in setting commutation rates

There are many non-actuarial reasons for commutation rates being lower than transfer values, such as cost management, the lump sum being optional and tax free, scheme design or the desire to maintain intergenerational fairness. Who holds the balance of power, is also a contributing factor.

In its report, Pensions: actuarial factors used to calculate benefits in UK pension schemes, published January 2021, the AMS found that actuaries advised trustees to set commutation rates below best estimate where the scheme rules provided such flexibility. The reasons cited were around market volatility and selection risk (where members in poor health are more likely to commute their pension for lump sum). However, these reasons were not always thought to justify the size of the difference between commutation rates and transfer values.

Frequency of reviews

Trustees usually review scheme factors every three years, alongside or following the scheme’s actuarial valuation. Unlike transfer out factors, commutation rates tend not to be market related and this means their value is fixed between reviews. While fixed factors can be helpful for members in planning their future retirement benefits, market movements between reviews can lead to poor value for members (or for the scheme). The AMS report recommends that three years should be the maximum time between reviews and suggests that more frequent reviews or monitoring would help trustees to keep an eye on whether the factors are moving out of line with market conditions.

What trustees can do

Trustees rely on the actuary’s advice to help them look after their members’ interests and should ask for clear advice from the actuary to understand how the assumptions for commutation rates and transfer values differ. Illustrative examples which show the impact of the commutation rates for members relative to the transfer values is a useful tool in this regard.

Trustees can ask for advice on commutation rates as part of the valuation process, not after it is concluded, so that they can have early discussions with the sponsoring employer, and reduce the risk of shocks further down the line after the valuation is concluded.

And where the scheme rules require the actuary to certify the factors as reasonable, the trustees can formally ask the actuary if they are able to do so.

Finally, trustees can introduce annual reviews or a quarterly monitoring framework to identify when commutation rates fall outside a given tolerance and take action when necessary.

What this means for members

Cash commutation continues to be a popular option, but scheme members don’t necessarily know if they’re getting reasonable value for the pension they are giving up. Often members have not taken advice to help them understand their options, yet the decisions taken at retirement affect the level of pension members receive for the rest of their life. The AMS report provides useful research towards helping actuaries help trustees to set fair value for members.