Cash Commutation [Noun / kæʃ kɒmjʊˈteɪʃən]. The right that a beneficiary has to exchange one type of income for another. More commonly referred to as a Tax-Free Cash Sum (“TFCS”).
As interest rates have fallen and life expectancy has increased Cash Commutation Factors (“CCFs”) have inexorably risen. But have they increased at the same rate as the cost of providing the underlying pension?
In the 1970s, members were expected to live perhaps fifteen years in retirement, with pensions that were level in payment, at a time when investment returns were high. Now, by contrast, members are expected to live perhaps twenty five years in retirement, will have at least half their pension increasing in payment, and future investment returns are forecast to be considerably lower.
“Acting in the best interests of scheme members” is frequently taken as the key “rule of thumb” to be followed by trustees, if not an overarching requirement. However, this misses the point.
Trustees’ paramount duty is to the terms of the Trust Deed. Insofar as member options are concerned, trustees do not have a duty to maximise the amount payable. Rather, they need to make sure they are exercising their powers properly, acting fairly and in good faith.
And this is really where the rubber hits the road. The Trust Deed will outline who sets the CCFs and, effectively, what they are able to take into account in determining them. Frequently, the Trust Deed will refer to factors being “actuarially equivalent” or “reasonable”, but these are not the same thing.
So what is reasonable to take into account in determining CCFs?
The answer to this question is one of ongoing discussion within the pensions industry and, as ever, the answer is nuanced. For example:
- Is it appropriate to choose unisex factors? And should these reflect the number of males and females in the scheme?
- Should factors reflect the pension increases that would have been provided (and is it okay to look at an average increase rate, for simplicity)? And where pension increases are not known in advance (for example, where they move in line with inflation) what allowance should be made for this?
- Should factors reflect the funding position of the scheme (is it right to pay out a “full” TFCS when the scheme is underfunded)?
- Is it right to take account of member-specific features (for example, the likely life expectancy of someone in ill-heath)? Or should we look at the mortality experience of the scheme as a whole?
- To what extent should factors reflect underlying market conditions (what if underlying market conditions are artificially low -or high- for example as a result of quantitative easing)? Do we need to believe in the permanency of any change in market conditions before aligning our CCFs with them?
- How often should we review factors? Should they change each month, like Transfer Values, or should they be retained for a longer period, to enable members to plan for their retirement? And what about the very long term and inter-generational fairness? Can we legitimately persist with factors that are considered unreasonable to avoid the excessive administrative cost that comes with frequent changes?
- Does it matter if CCFs don’t reflect fair value? After all, members can always vote with their feet and not take their TFCS. Indeed, in this age of ‘freedom and choice’, members may well have the alternative of taking cash from their Defined Contribution pension pots.
- Can we look at what every other scheme is doing? Provided we’re in the middle of the herd we’re safe, right?
So what should trustees do?
Importantly, as we noted earlier, the starting point is the Trust Deed. However, I would suggest there are a few “must do’s” beyond that.
Clear communication is key. Personally, I would like to see members encouraged to take advice when it comes to taking their TFCS. Indeed, legislation already requires this for Transfer Values in excess of £30,000.
It’s also important for CCFs to be reviewed regularly. For example, the Pension Protection Fund review their factors annually. But why not treat the TFCS more like a Transfer Value, where it can vary each month (and could be fixed at, say, six months prior to retirement, to enable members to plan)?