4 - DB Schemes

Question 1

What are the 3 main forms of DB scheme?

Answer 1

• Traditional (aka final salary): Each year accrue a fixed fraction of your final benefit (eg 1/60th) and on retirement get a benefit based on your salary when you retire.
• Career Averaged Revalued Earnings (CARE): Each year you accrue a fraction of your earnings in that year instead of final year. Early years get revalued to account for inflation up to when you retire. This is cheaper and easier for the employer to budget for.
• Hybrid: This includes both DB and money purchase elements. Either element could be dominant. Eg they could have a DB scheme but only up to £30k salary, after which they contribute to a DC scheme.

Question 2

Hybrid Schemes

What is the difference between:

• A DB scheme with money purchase underpin; and
• A money purchase scheme with DB underpin.

Answer 2

DB with MP underpin is defined as “higher of benefits calculated on DB basis and the benefits arising from a MP plan”.

Money purchase with DB underpin is more like a standard money purchase plan, but with a guaranteed minimum level of DB benefits (kind of like insurance on the side).

Question 3

What options are available for accruing additional benefits under DB schemes?

Answer 3

• Money Purchase AVC (additional voluntary contribution) - Building up a pot of cash alongside the DB scheme. PCLS will be based on 25% of both parts, but can be taken entirely out of the DC pot to maintain the DB benefit.
• Added years - Paying an actuarily calculated AVC sum to buy extra years of service (eg if you serve 37 years you could pay for 3 extra years worth of pension to take you up to a 40 year cap).
• Additional flat rate pension - Paying an AVC for a fixed additional pension income (eg £1000 pa). This is rare.

Question 4

2 ways in which benefit may be adjusted based on retirement age

Answer 4

• If the pension is taken before normal retirement age an actuarial adjustment will be made to account for the fact that the benefit will be paid for a longer period (the benefit amount must reduce so that the cost is the same).
• Some schemes may offer higher income in earlier years before state pension kicks in, to achieve a flat income level through retirement. This is known as a bridging pension

Question 5

What rules and laws determine the terms of a DB pension?

Answer 5

Most terms are determined by the scheme rules not law.

Things like retirement age, amount of benefits paid, how benefits are calculated (etc.) can all be set up in many different ways depending on how the scheme is set up.

Scheme rules also determine things like minimum age requirements, differences between groups of employees (blue collar/white collar), probationary periods before benefits start to accrue etc.

Question 6

Who pays contributions into an occupational DB scheme and how much do they pay?

Answer 6

This is down to the scheme rules, but ultimately the employer is responsible for contributing whatever is required to provide the benefits.

The scheme rules may require some contributions from the employee.

In some cases rules have been introduced to limit the contribution the employer will have to make. Benefits will have to be reduced if the maximum contributions are too low to cover them.

Question 7

What determines the growth rate of benefits once they start being paid out?

Answer 7

There are mandated minimum growth rates.

These depend on several factors, including when the benefits were accrued and whether the scheme was contracted out of the state second pension.

Question 8

What is the Guaranteed Minimum Pension (GMP)?

Answer 8

This is a minimum pension benefit amount required to be paid by a pension scheme in order to allow it to be contracted out.

The mandated minimum growth rates of this part of the pension are different to the excess over GMP.

It is only relevant for benefits accrued up to 1997.

Question 9

What are the mandated minimum growth rates for the different sets of benefit accruals pre 1997?

Answer 9

Depends on when the benefits were accrued

• GMP portion (pre 1988): No escalation required. The state is responsible for paying GMP growth which is paid along with the state pension.
• GMP portion (1988-1997): Scheme is responsible for CPI growth rate, up to a maximum of 3%.
  
  • If the member reached SPA before 6/4/16 the state tops this up to full CPI growth, otherwise they do not.
• Non-GMP portion (pre 1997): No statutory minimum growth rate.

Question 10

What are the mandated minimum growth rates for the different sets of benefit accruals post 1997?

Answer 10

Depends on when the benefits were accrued

• Benefits accrued 6/4/97 - 5/4/05: Scheme pays CPI growth rate up to a 5% maximum (known as limited price indexation LPI). State does not top up.
• Benefits accrued post 5/4/05: Scheme pays CPI growth rate up to 2.5% maximum. State does not top up.

Note that CPI is measured in September.

Question 11

What is Pension Increase Exchange and considerations around it?

Answer 11

Pension Increase Exchange is when a pension scheme offers members the choice to give up scheme specific growth rates in return for a higher initial benefit level.

Note that the mandated minimum growth rates must still be achieved.

This would result in a higher valuation of the benefit on crystallisation, which allows the member to take a higher PCLS, but would use a higher proportion of the LTA.

The Pensions Regulator keeps a close eye on these offers to ensure members aren’t manipulated (no cash incentives allowed, must have at least 3 months to decide).

Question 12

Calculating the PCLS

What are the two methods by which DB schemes provide a cash lump sum?

Answer 12

• There might be specific provision for a lump sum on top of the specified ongoing benefit level. Here the tax free PCLS is easy to calculate, 25% * (lump sum + 20 * benefit level).
• The alternative is a commutation factor, eg 12:1, which means the member can exchange £12 of annual income benefit for a £1 lump sum on commencement. Now it is more complicated to calculate the maximum PCLS, since there are lots of options for how much lump sum to take.

Question 13

Calculating the PCLS

How do you calculate the PCLS that should be taken via commutation of the pension income?

Eg. £20k original pension (pre-commutation), 15:1 commutation factor

Answer 13

PCLS = 20 x Precommutation pension x Commutation Factor

divided by ( 20 + (3 x Commutation Factor) )

Eg. PCLS = 20 * £20k * 15 / (20 + (3 * 15))

= £6,000,000 / 65 = £92,308

In this case they should take £92,308 which costs £92,308/15 = £6,154 out of their pension income, so they get a £13,846 ongoing pension benefit.

Question 14

Leaving Service

What happens if somebody leaves service within the first 2 years?

Answer 14

• The scheme can choose to offer you a preserved pension or a ‘short service refund lump sum’, which is a refund of your personal contributions (but you lose all employer contributions). You will be taxed at 20% on the first £20k and 50% above that.
• After 3 months service the employer must offer a Cash Equivalent Transfer Value (CETV) which you can take to another scheme, or a preserved pension within the scheme (if allowed by scheme rules).

Question 15

Leaving Service

What does the member get if they leave employment after 2 years?

Answer 15

After 2 years you are entitled to a preserved benefit within the pension scheme.

This will be grown at manadated rates up to your normal retirement age.

The mandated growth rates depend on whether the pension scheme was contracted out (prior to 6/4/16) and when you left service.

Question 16

Leaving Service

What are the growth rates for non-GMP preseved benefits?

[Note this includes 100% of non-contracted-out pensions and the excess of contracted-out pensions above GMP]

Answer 16

Based on the leaving date from the company:

• Pre-1986: No minimum growth rates.
• 1986-1990: CPI up to 5% on accruals since 1985.
• 1990-5/4/09: CPI up to 5%.
• 5/4/09 onwards: CPI up to 2.5%.

Question 17

Leaving Service

What are the growth rates for the GMP portion of preseved benefits?

[Note only contracted out schemes (which were available pre-April 2016) have a GMP portion]

Answer 17

There are three potential methods of growing the GMP portion.

• s.148 orders: In line with the increase of national average earnings.
• At a fixed rate, depending on when they left service. This was 8.5% for leavers pre 1988 but has been decreasing and for leavers since 6/4/17 is only 3.5%.
• For leavers pre 6/4/97 the revaluation could be limited to 5% if the employer paid the DWP a ‘limited revaluation premium’. The DWP would then make up the difference to the s.148 amount.

Question 18

Pension Transfers

How are benefits categorised for the purposes of pension transfers?

Answer 18

• Flexible benefits: Money purchase benefits, cash balance benefits and any benefit defined by reference to a fund.
• Safeguarded benefits: Everything else.

Question 19

Pension Transfers

What is the process for calculated CETV?

Answer 19

There are a lot of high level assumptions made by the scheme in the calculation, but the process is basically:

1. Calculate the preserved pension amount at the leaving date (including any cash lump sum);
2. Revalue the benefit up to normal retirement age (subject to the minimum statutory growth rates);
3. Calculate the capital cost of buying that amount of benefit (an annuity rate essentially, calculated by actuaries);
4. Discount that value back to a current capital value on the date of leaving (again subject to actuarial calculations).

Question 20

Pension Transfers

Why might the CETV be higher or lower than expected?

Answer 20

CETV could turn out to be lower than expected if the scheme is underfunded. The scheme then has less cash available and will limit their CETV offer.

Alternatively it could be quite high, if the scheme wants to get rid of the long term liability and associated risk.

Question 21

Pension Transfers

Who can make a pension transfer?

What are the requirements?

Answer 21

Anybody with more than one year until normal retirement age can transfer their safeguarded benefits to a DC scheme.

They must obtain advice from an “authorised independent adviser”, unless the CETV is below £30k.

The advisor doesn’t necessarily need to be an IFA, but must be from suitably qualified (eg AF3 qualified from CII) and independent from the employer.

Question 22

Pension Transfers

What is the process for a pension transfer?

Answer 22

• Member makes a transfer request to the scheme.
• The scheme has 1 month to notify the member of the requirement to take advice.
• Within 3 months they must provide a transfer value as at a “guaranteed date” which falls within that 3 month period.
• Within 10 days of the guaranteed date the member is given their statement of entitlement (including details of the transfer value and benefit entitlements).
• Within 3 months of the guaranteed date the member must request the transfer, including proof they took advice (FCA registration no.)
• The scheme must check FCA registration and if they’re happy advice was provided make the transfer within 6 months of the guaranteed date.

Question 23

Pension Transfers

What is the Transfer Value Analysis System (TVAS)?

What is the figure that is output from the analysis?

Answer 23

TVAS is an approach the Pension Transfer Specialist (PTS) will take to evaluate the value of the CVAT offer against the benefit entitlement under the pension scheme.

It outputs a figure for critical yield, which is the growth you would need to achieve on the DC funds to end up with the same level of benefit.

Note that achieving the critical yield doesn’t necessarily mean the member was better off transferring, since there are a large number of assumptions involved.

Question 24

Pension Transfers

What are the standard assumptions in TVAS?

Answer 24

• Annuity Interest Rate (AIR): Based on 5 year gilt yields, this determines how much capital you need on retirement to buy the income. A higher AIR means a lower critical yield, since you need less in your DC scheme to buy the required annuity income.
• Revaluation Rate: This is the assumed growth rate of the current stated benefit income level until retirement, which assumes 2% inflation and 4% earnings growth. The higher this is the higher critical yield you will need to keep up with the increase in value of income until retirement.
• Indexation/Escalation Rate: This is the growth rate of the income level once in retirement, 2% inflation and 4% earnings growth assumed. Again a higher rate will result in the annuity becoming more expensive and a higher critical yield is required.
• Mortality: Taken from published mortality rates, the longer life expectancy is the higher critical yield you’ll need to provide the income.

Question 25

Pension Transfers

What other considerations are there in advising on pensions transfers other than just whether the critical yield can be achieved?

Answer 25

• Customer’s attitude to risk and capacity for loss (adventurous investors more likely to transfer to DC);
• Other benefits in the DB scheme such as death benefits or scheme specific increases;
• The funding position of the DB scheme (if it might go bust maybe you’re better off taking the cash);
• Likelihood of early retirement - You would need to compare the actuaries reduction of benefit from the DB scheme due to early retirement, with the projected DC fund value to the earlier retirement date.

Question 26

How does early retirement work for DB schemes?

Answer 26

The DB scheme will have a normal retirement age and benefits offered will be based on retirement at that age.

Taking benefits (i.e. retiring) before that age is entirely at the discretion of the scheme rules, as it the level of benefit you might be entitled to. In any case the earliest possible retirement age is 55 (legal minimum).

Benefits would be lower of course, due to the shorter time available to grow funds and the longer time for which benefits would be payable. The scheme will use actuarial calcs to calculation an adjustment to benefits for early retirement, but ultimately they can state what they want.

Question 27

What are the rules around ill health and DB schemes?

Answer 27

It may be possible to take benefits early (under age 55) in cases of ill health or serious ill health.

As usual this depends on the scheme rules. The could allow you to take your current level of benefits, or even the level of benefits if you had continued working until normal retirement age.

As with DC schemes it’s possible to commute benefits into a lump sum provided they haven’t yet come into payment, you have 12 months left to live and you have enough LTA to cover the lump sum (or any LTA left if over age 75).

Question 28

How are death benefits paid from a DB scheme?

Answer 28

Death in service can result in either income (% of members benefits) or lump sum benefits being paid (income is taxed on the recipient, lump sum subject to LTA and 55% tax for excess).

If death occurs when the benefits are in payment there might be a percentage of income paid as a death benefit. This will most likely be based on the income level before any commutation took place!

Question 29

What is the purpose of DB scheme valuation?

Answer 29

A DB scheme will have a portfolio of assets (usually investments like shares, bonds, property etc.) and a series of liabilities (future benefits it will have to pay for members).

Over time the size of both the assets and liabilities will change. It is important to monitor these movements to ensure that the assets are sufficient to pay off the liabilities in the long run.

The employer needs to run valuations so that it can report to shareholders (if a big deficit opens up it will impact the employers profits), and the PPF wants valuations to assess the level of risk of the scheme and how much it will cost the PPF if the scheme fails.

Question 30

What are the four methods of DB scheme valuation?

Answer 30

• Ongoing fund valuation;
• IAS 19 valuation;
• Insolvency valuation; and
• Section 179 valuation.

Question 31

What is the ongoing fund valuation method?

Regularity of valuations?

Answer 31

Ongoing fund valuation is the least stringent valuation method.

It assumes the fund keeps running and keeps being funded.

Assets are measured at market value and assessed against the ability to meet liabilities as they fall due (called technical provision).

Meeting this technical provision is the basic statutory requirement of a DB scheme. The actuary will draw up the required contributions in order to achieve this.

It is required to be done annually, or once every three years with an actuarial report in the years in-between.

Question 32

What is the IAS 19 valuation method?

Answer 32

This is a more stringent accounting method for the employer than the ongoing valuation method.

It requires them to bring the pension assets and liabilities “on balance sheet”, which means that any movement in the value of the assets or size of the liabilities will feed directly into the employers profits.

Assets are valued at market value and liabilities are valued with reference to AA rated bonds.

Question 33

What is the insolvency valuation method?

Answer 33

Insolvency valuation is even more stringent than IAS 19 method and is used when the scheme enters the PPF.

Liabilities are assessed by finding out what an insurance company would charge to take care of them.

After deducting the value of any assets in the fund this tells the PPF how much it will cost them to cover the shortfall.

Question 34

What is section 179 valuation?

Answer 34

Section 179 is similar to insolvency valuation but slightly lighter touch.

It is used by the PPF to establish the level of risk in a fund and thus how much of a levy to charge them.

Naturally it is similar to insolvency valuation since that’s the cost the PPF would incur if the scheme were to go into the PPF.

Question 35

When does TPR require action to be taken and what actions might be expected?

Answer 35

TPR requires a recovery plan to be put into place if a scheme is in deficit in relation to its technical provisions (i.e. ongoing scheme valuation method).

Measures that the employer might have to put into place are increased contributions (by them or by members), reducing future accruals, delaying normal retirement age, changing investment strategy, changing the scheme basis (eg to CARE) or closing the scheme to new members (or even to current members).

Basically pretty much anything that will enable them to meet the liabilities, even if it’s bad for members of the scheme (that’s the employers problem).

Question 36

Professionals

Who is the “scheme administrator”?

Answer 36

The “scheme administrator” is responsible for running the DB scheme, registering it with HMRC, compliance with HMRC rules, taking care of tax relief and providing information to members.

Typically this is the employer.

Question 37

Professionals

Who are the “scheme auditors”?

Answer 37

The “scheme auditor” must be a registered auditor, appointed by the trustee.

They are responsible for producing a report to specify whether contributions have been paid in accordance with either the schedule of contributions from the actuary, or the scheme rules.

Question 38

Professionals

Who are the trustees?

TPR rule: what must they report to TPR?

Answer 38

The trustees are responsible for protecting the members interests.

The assets are held in their name and they are responsible for appointing the scheme auditor and ensuring that the employer, scheme administrator and others operate in accordance with the scheme rules.

Also responsible for drawing up the “statement of investment principles” against which scheme investments can be measured.

They must report to TPR if any contribution that is due is materially late (defined as more than 30 days).

Question 39

Professionals

What are the rules around who can be a trustee?

What are the requirements for the board of trustees?

Answer 39

To be a trustee you must be at least 18, sane, not bankrupt and not barred by TPR from the role.

There is a requirement for 1/3rd of the board of trustees to be “member nominated trustees”, selected by the members of the scheme themselves. This rule can be ignored if:

• All of the members are trustees;
• There is only one member of the scheme;
• All trustees are independent of the empoyer; OR
• It is a small insured scheme under the definitions.

Question 40

Public Sector

Who is responsible for public sector pension schemes?

Answer 40

Mostly the governement (NHS, schools, local government).

However police and firefighters pensions are run by individual local authorities.

Question 41

Public Sector Schemes

Advantages to them

Answer 41

• Fully protected against inflation at retirement;
• Early retirement (i.e. ill health) benefits greater than private sector; and
• Transfer between public sector schemes via the “transfer club”.

Question 42

Public Sector Schemes

What is the transfer club?

Answer 42

Most public sector schemes belong to the transfer club.

This means that if a member of one of these schemes moves to a different public sector job, where the scheme is also in the transfer club, they can move their pension with them.

They will be a normal member of the new scheme, however the years of service will include the number of years they worked in their old job. So the benefit will be based on their new job but the years of service is based on both jobs together.

Question 43

Public Sector Schemes

Are there any limits on the ability to transfer out?

Answer 43

Government ministers can limit the value of transfers out of a scheme if there are too many people doing it and it will damage the remaining members.

Question 44

Public Sector Schemes

What is the typical level of benefit?

Answer 44

Historically the benefit level accrued for each year of service was 1/80th of final salary as income and 3/80th as cash lump sum.

For new members and new accruals for existing members they have moved to a CARE basis, however members within 10 years of retirement age when this happened were protected.

Question 45

In what circumstances are these professionals not required:

• Auditor;
• Fund Manager.

Answer 45

• Auditors not required for schemes that are insured and earmarked;
• Fund Managers not required for schemes investing entirely in insurance policies.

Question 46

Summary of Mandatory Growth Rates

What are the 2 different sets of mandatory growth rates?

What is the key question for each regarding timing?

Answer 46

• Pension at retirement: Growth rate depends on the year of accrual.
• Deferred Pension: Growth rates depend first on the year they left the company, to a lesser extend the year of accrual has an impact.

Question 47

Summary of Mandatory Growth Rates

Growth rates for general pensions (not deferred) based on year of accrual

Answer 47

Question 48

Summary of Mandatory Growth Rates

Growth rates for deferred pensions based on year of departure

Answer 48