Does your scheme need a U-turn on commutation factors?

The most immediate challenge facing many pension schemes as a result of the sharp rise in long-dated gilt yields following the “mini-budget” on 23 September has been collateral calls on their Liability-Driven Investment (LDI) strategies.

When this has been sufficiently stabilised, trustees will need to take stock and respond to a range of other consequences. For many schemes there may still be a good news story of an improved funding position, leading to a possible acceleration of their de-risking journey plans and even potential buy-out.

However, there is an area which trustees of DB schemes will need to turn their attention to quickly. Although the rise in interest rates does not impact the pension which a member can expect to receive, it has significantly reduced the “actuarial value” of that pension. For example, a typical transfer value calculation as at 30 September  2022 may now be around 50% lower compared to a calculation based on market conditions as at 31 December 2021.

This development raises questions about the continued appropriateness of the terms trustees offer for other member options - most significantly cash commutation factors and early retirement reduction factors - often referred to under the umbrella term ‘actuarial factors’.

Significant changes

Typically, trustees have a significant degree of flexibility on the terms they set for such actuarial factors, and maintenance of stability over time through the ups and downs of market conditions is a conscious design feature which keeps the administration easier, as well as providing some predictability for members. 

However, the change in markets conditions has been a very significant one and, unusually for the last couple of decades, leads to the possibility of existing terms being too generous rather than not generous enough. 

One aspect to consider is that schemes which have been on the (often challenging) path of improving cash commutation factors may find these are now suddenly too generous to sustain and may even have adverse funding consequences. For example, based on 30 September market conditions, around 50% of schemes may have commutation factors which are more generous than the corresponding terms typically offered by insurance companies - at the start of the year this figure was expected to have been less than 5%. Similar issues may arise for the scheme’s early retirement reduction factors. Trustees will have important judgments to make, as they may not want to go too far in the other direction in case gilt yields fall significantly again.

Adding up

The vast majority of members will exercise one or more member options in the lead up to or at retirement. Although “normal activity” in relation to member options is gradual and the impact on the scheme’s funding position often comes out “in the wash” at triennial actuarial valuations, the impact of member options adds up over time. The issue is set to become more prominent as schemes advance on their de-risking journeys, and other causes of variability in the funding position are gradually reduced.

This might be a moment which moves some trustees at least to put actuarial factors on a more robust market-related footing where, like transfer values, cash commutation factors and early retirement factors are updated automatically on a regular basis. For schemes with a buy-out target in mind this might have been a natural evolution in any case to align themselves to how an insurer would approach setting terms for such options.