The exercise of discretion on commutation factors in defined benefit schemes: time for change?

This paper is motivated by the findings of a review in 2020 by the Institute and Faculty of Actuaries, which found that commutation factors differed widely between schemes, they were typically significantly below transfer value factors, and that in nearly 30% of cases, trustees did not act fully on the actuary’s advice. The author suggests that regulation of commutation factors, instead of factors being decided by trustees’ discretion, could be a suitable way forward. The focus is commutation factors for UK-defined benefit pension schemes, having regard to the law that governs the discretion available to trustees. Relevant legal principles are explained, including the requirement for trustees’ decisions to be made for a proper purpose and to be made with due care and skill, taking into account relevant considerations. These principles are applied to the setting of commutation factors. The author describes four methods trustees may use to assess the actuarial equivalence of the pension being exchanged for cash, which is ordinarily part of the process to set commutation factors. None of the four is entirely satisfactory, although it is suggested that there are some advantages in viewing commutation as a transaction between trustees and members. The possible use of market-consistent factors is one of the topics discussed. Commutation factors can also incorporate guarantee charges and/or deductions for underfunding, although the author explains the argument that the latter should not be commonly applied. The role of employers’ and members’ expectations is discussed and can explain why commutation factors can reasonably be less than 100% of actuarial equivalence. It is argued that the impact of commutation on employers’ contributions can in some circumstances justify adjusting commutation factors. The paper also considers other reasons sometimes put forward for reducing factors: tax, utility and optionality. The author also argues that reviewing commutation factors only every three years sits uneasily with legal principles. Further enquiry is suggested as to the responsibilities in law of actuaries when certifying that factors are reasonable. The author suggests that trust law permits trustees to use their discretion in a way that can produce a wide range of outcomes, which may be regarded as unsatisfactory for determining what may be an important part of a member’s reward package, and that a better approach may be for the government to introduce regulations on commutation factors, including a form of disclosure to help inform members’ choice on exercising the option.