Chapter 5 - Defined Benefit Schemes Flashcards
Hybrids and other scheme variations - what is it
DB scheme with DC underpin - provides bens that are higher of… (2), transfer value for who and higher of (2) and why is this scheme beneficial for early leavers (2)
DC scheme with DB underpin - what does it offer and how does it operate
Is a DB scheme that also has some characteristics of a DC scheme.
DB scheme with DC underpin provides benefits that are higher of the bens calculated on normal DB basis or bens arising from DC plan. Offers transfer value for early leavers that will be the higher of the fund built up in a DC arrangement and transfer value based on the DB provided by the scheme. Basically bens provided will be higher of DB or DC arrangement. This type of scheme beneficial for those leaving the scheme before NRA because;
- DC account which will still grow in line with underlying investments may produce better pension at retirement than a DB pension.
- if transfer value taken it is larger of DC amount or CETV.
DC scheme with DB underpin - offers DC bens with minimum level of pension related to their final salary. Operates by having usual DC account plus separate account to meet cost of guarantee when insufficient amount in members account.
Defined Cash schemes - how are bens limited, prior to PCLS provided what and and schemes are now what
Career average schemes - how bens determined, tends to what, cost to employer, DB better for who and CA useful for who, how can earnings be revalued and bens calculation based on and how (3)
Example - Salary of 20k, revalue rate of 2.5% and two years to retirement with 1/56 accrual rate
Defined cash - limited bens so that it fell within pre a day HMRC limits for TFC. Prior to intro of PCLS, schemes provided lump sum of 3/80s of final pay for each member. These schemes are now only 100% cash for transitionally protected pre a day bens.
Career average schemes - formula to determine benefits based on average earnings over members career which tends to reduce bens payable to member and thus costs to employer. DB scheme better for those where salary increases towards end of career but CA scheme may be useful for those who salary reduces (reduction in hours etc).
Earnings can be revalued in line with inflation or assessment of earnings inflation. Career progression ignored due to each year being considered in isolation rather than total pension accrual being based on salary at retirement.
Bens calculated based on pension accrual on a year by year basis;
- member accrues proportion of their salary for each year of pensionable service (e.g. 1/56th)
- for active members, amount accrued each year based on their salary that year.
- each years accrual revalued at retirement in line with scheme rules e.g. inflation or fixed amount each year.
E.g pensionable salary of 20k + increased at fixed rate of 2.5%. Two years to NPA - 20k1/56 = 357.14 accrued pension this year. Then revalued by 357.141.025squared (this changes with how many years left). Then add up other years to get career average amount.
Topping up DB schemes - how can they top up bens (2)
In-house AVCs - who usually meets costs and if not what else can they get (2), benefit accrual first way;
DC basis - invested into what, can take how whole of fund as what, max and benefit of taking all.
Member of DB scheme can top up bens by using AVC offered by employer or via personal or stakeholder pension.
In-house AVCs - employer usually meets costs associated with setting up and administering in house arrangement and at worst can negotiate discounts with provider or increased allocation rates. Benefit accrual can happen in two ways;
- DC basis - AVC conts are invested into DC fund. May be possible to use this whole fund as PCLS at retirement and total amount of PCLS to be taken is still max 25% of total value of bens. If whole of AVC taken the less of DB scheme commuted for PCLS. This means will have higher initial scheme pension from DB and future escalations in payment will be based on higher amount.
Topping up DB pens - In-house AVCs cont…
On an added years basis - what is it, calc’d using what (2), how are contributions invested, charges for conts and assumptions, why are actuaries conservative with assumptions, what/who is added years best for, once reg started, can only take added years when and transfers and if leave AVC
If AVC in DB scheme that may be possible to buy added years of service and this is calculated by scheme actuary based on number assumptions;
- assumed salary increases and growth of underlying fund.
Contributions expressed as a %
AVC contributions are invested along with the main scheme investments and no charges to contributions but costs built in to assumptions of cost for adding year. Actuaries conservative when making assumptions so that cost of providing bens does not exceed the AVC contributions paid in. Added years AVCs best for employees who expect salary to increase quite quickly.
Once regular contributions have started to purchase added years some schemes do not allow them to be stopped while member remains in service unless financial hardship.
Can only take when main bens are taken and bens can only be transferred in entirety. If leave AVC conts must stop.
Rules and operations -
Setting up scheme - governed by who, how what for benefit of who, rules and must adhere to what (2)
Normal Pension Age - who sets and employer will…, retirement and ben taking and when can they take bens
Bridging Pension - what is this and permitted under what acts (2)
Eligibility - DB & AE and how does it what, rules (4), if used as qualifying pension scheme
Setting up scheme - DB scheme governed by trust. Under this, trustees hold scheme property for benefit of the members. Must have its own set of rules. Must adhere to Pension Act 1995 & Pensions Act 2004.
Normal Pension Age - scheme sets this and age that employer will contribute until. They do not have to retire to take benefits from the scheme. Eligible to take bens from NPA (55).
Bridging pensions - some pay this when schemes NRA is lower than SPA i.e. higher pension paid until SPA is reached. Permitted under Finance Act 04 & 13.
Eligibility - can offer DB as part of auto-enrol and starts as DC then after period of time asked to join DB. Rules define who can join and common ones are;
- minimum entry age (18 or 21)
- probationary or waiting period before employee can join (usually 1 year)
- differentiation between categories of employee (management, staff etc)
- and different level of Bens offered to each category
Can’t be made compulsory but if used as qualifying pension scheme then EJ’s must be auto-enrolled. Can offer NEJ+EW this membership and all can opt out if they wish
Rules and operations - Accrual of benefits - pensionable service, renumeration and accrual rate (brief description on what they are)
- Contributions - tax relief on what via what (2), how are employers conts paid and tax relief for them
Pensionable service - laid out in scheme rules and usually employees period of membership of the scheme. May not start until waiting period has finished.
Pensionable renumeration - rules lay out definition of salary used when determining bens.
Accrual rate - rules define rate at which benefits accrue for each year of pensionable service
Contributions - Can award tax relief of members conts via net pay or RASM. Employers conts are paid gross and deductible as business expense.
Employers contribution - what must contribution meet, costs depend on what (5), when do they contribute and what is funding rate.
Employees contribution - condition of membership and what is their contribution (2)
Employer must contribute and its contribution must meet cost of providing benefits on retirement/death. Open ended commitment for employer as cost depends on number of factors;
- level of final renumeration in future
- investment returns achieved by underlying pension fund
- annuity rates available when member retires unless income comes directly from schemes assets.
- cost of providing guaranteed bens to members who leave scheme before NRA
- profile of membership (age and marital status as this determines period of bens and level of spouse’s bens)
Employer contributes on annual basis. Scheme’s actuary calcs regular contribution level which must be at least every three years - known as funding rate.
Employees contribution - as cost is unknown, condition of membership to pay certain amount towards costs. Employees contribution is;
- % of pensionable salary
- rate that remains constant unlike employers that can vary.
Normal retirement - DB schemes were what pre 04/16 and affected what, what did scheme do to counter this, contracted out between 78-97, when abolished and rights, GMP payment needs to be what?
Member SPA pre 04/16
- Pre 88, accrued 88-97, no accrual, pen for service pre 04/05 and PFS post 04/05.
rate of increase - what determines and stat increases
Pre 04/16 many DB schemes were contracted out and therefore members did not accrue and SERPS or S2P. Instead, scheme provided a minimum level of benefits to replace SP given up.
If contracted out between 04/78-04/97 they built up entitlement to guaranteed minimum pension (GMP) which was same as they would have earned under SERPS. Abolished 04/16 but those in that period will still have rights to GMP. GMP payment needs to escalate in prescribed way;
Member reached SPA pre 04/16
- Pre 88 GMP - scheme does not have to provide any escalation and state is responsible. Will be in line with CPI and paid along with other state pensions.
- GMP accrued 88-97 - scheme responsible for increases in GMP in line with CPI to max of 3% and any additional % is paid by state.
- Non GMP accrual - no requirement for increases
- Pension for service after 04/97 but pre 04/05 - escalate in line with CPI up to max 5%
- Pension service post 04/05 - as above 2.5% max
Rules of scheme determine rate of increase of rest of pension. Stat increases based on RPI then post 2011 CPI.
Normal retirement age - GMP escalation
reached SPA post 04/16 - why is starting amount calc’d, GMP treatment after new SP, when is calc of starting amount done and what does this mean.
Escalations post 04/16 - pre 88, GMP between 88-97 and 3 others.
Reached SPA on or after 04/16 - entitled to new SP and starting amount calculated to ensure not worse off under new rules. Intro of new SP changed how GMP entitlement is treated once start receiving SP. Calc of starting amount done only as at 04/16 meaning no allowance is made to account for CPI increases paid by scheme is respect of post 88 GMP.
Stat escalations in payment as per the above (04/16)
- Pre 88 - does not provide escalation
- GMP between 88-97 - scheme must pay escalations in line with CPI up to max 3%
- Non GMP accrual & pension in service same as other one (5% then 2.5%)
Pension increase exchange - what is it, can only be offered when, why popular with schemes (3), advantages for members (3) and drawbacks for members (4)
This is where member is offered option of giving up future guaranteed increases in pension in return for higher initial pension with no future increases other than statutory. Can only be offered if schemes offer escalations payment. Popular with DB schemes because;
- escalating payments are expensive and increased longevity means costs are rising.
- cost of unknown increases is an unknown liability e.g. life expectancy and inflation and therefore this reduces future liabilities.
- employer does not suffer large one-off cost as only additional cost is higher initial pension which may be worth less than equivalent future pension escalation.
Benefits to member;
- higher initial income whilst healthy and active
- may be entitled to higher PCLS
- if poor health or lower life expectancy get more whilst alive
Drawbacks to members
- if live longer than average then end up worse over long term
- value against LTA test will be higher and LTA issues may occur
- can result in pension input that exceeds AA
- may affect entitlement to means-tested state bens
Pension increase exchange - why is it difficult to assess (3), why does it cause issue for LTA, what is an incentive exercise and what tests must be met (2), 5 principles made why and what are they
Difficult to assess as depends on how long they live and how fast pension expected to increase on average + increases in line with CPI or RPI difficult to predict. Could also cause issue for LTA due to x20 benefits and they potentially have benefits elsewhere.
TRP - an incentive exercise (e.g. PIE) is invitation or inducement provided to entice changing form of their accrued bens which meets both of the following tests;
- providing its used to reduce risk or cost for pension scheme or sponsors
- not usually available to members
These exercises must meet 5 principles in order for TPR to feel member can make informed decision;
- clear, fair and misleading
- open and transparent
- manage conflicts of interest
- involve trustee consultation
- include IFA
Pension increase exchange - IE’s for pensions: a code of practice - what count as IE’s (2), seven principles of this code and what else are treated as IE’s (2)
Voluntary code of practice been produced as well as TPR principles. Pension increase exchange and enhanced transfer value count as IE’s. Seven principles;
- No cash incentives
- Advice - advice should be provided for both and mod should have value compiled and guidance provided to member.
- Communications - should be fair, clear and not misleading
- Record keeping
- Sufficient time - no time pressure
- Over 80 - only offered on opt in basis
- roles and responsibilities - need to act in good faith
This also apply to small pots and TCLS and are these are treated as IE.
PCLS at normal pension age - what determines PCLS, what does some schemes do, usually PCLS provided by and how does PCLS reduce pension
-E.g. work out new pension - Pension of £24k with 20 years service and accrual rate of 1/60th. PCLS 3/80ths and factor of 12:1 and final renumeration of £72k
- if contracted out pre 04/16 what cant be used for PCLS and the effect this has and when may this arise (3)
Rules of scheme determine PCLS (e.g. 3/80ths) and some accrue pension and PCLS separately. More unusual for pension to be commuted to provide PCLS as follows;
- rules of scheme specify commutation factor used to reduce pension e.g. 12/1 = every £12, £1 reduced.
Pension of £24k with 20 years service and accrual rate of 1/60th. PCLS 3/80ths and factor of 12:1 and final renumeration of £72k
- 203/80ths72k = 54K
- 54k/12 = £4,500 = 24k-4,500 = £19.5k new annual amount
Scheme contracted out pre 04/16 cannot allow part of GMP to be exchanged for cash which can restrict lump sum when non-GMP part of pension is small. May arise when;
- low earnings retires from scheme offering pension with rate of 1/80th
- has substantial non pensionable earnings
- retires early on reduced pension
PCLS at NRA - what do they check, if pension and PCLS separate how is max PCLS worked out, why is commuting more complex, Pensions Tax Manual formula***- LEARN THIS
E.g. work out max PCLS & residual pen if can- NPA 65, precomm pen = 30k and salary of 90k. Comm factor 15:1
If pays PCLS in line with what better than what
When bens taken check takes place to ensure not over 25% TFC. If pension and PCLS separate, pension*20+PCLS = notional value and PCLS cannot exceed this.
When commuting, more complicated as residual pension will depend on PCLS taken and comm factor. Complex scenario as not possible to calc residual amount until PCLS is taken and vice versa. Pensions Tax Manual has formula that must be used to calc max PCLS for DB scheme.
- PCLS = (20precomm pensionfactor)/(20+(3xfactor))
Max PCLS = (203015)/(20+(3*15)) = 9m/65 = £138,462
Residual pen = 30k - (max PCLS/15) = £20,769
If scheme pays PCLS bens in line with HMRC rules then will likely get more than those with scheme accrual rates.
Early retirement - can take bens when (2), how are bens accrued an reduced if taking early, what can it lead to and what else reduced
Can take bens before scheme retirement age and at 55 without retiring.
Bens are accrued in usual way up to date of early retirement and then reduced by an early retirement factor e.g. pension reduced by 0.5% for every month between date of retirement and NRA. Can lead to significant reduction e.g. 30% for retiring 5 years early and PCLS also reduced.
Ill-health early retirement - ways to calc pension (3), if <1 year to live can what and how calc’d, lower than what and how is IHLS formulated, pre 75 commutation (3) and when paid post 75 (2)
Rules define how to calc pension on ill-health early retirement and can be one of the following;
- based on service to date of early retirement but without penalty
- based on prospective service to NRA and salary at retirement without pen.
- somewhere between these two.
If less than a year to live can commute whole of pension as lump sum and calc’d using commutation factor selected by scheme admin. Ofter lower than PCLS factor. Usually calc’d by available PCLS+residual pension*comm factor.
Commutation for DB only applies to crystallised bens. Payment of ill-health lump sum pre 75 is BCE and is tax free as long as it does need exceed LTA. Can be paid post 75 if some LTA remaining and taxable at PAYE.
Bens on death - what do schemes rules outline and if expression of wish beneficiary when paid
Death in service;
- Lump sum death ben - when paid, amount payable and what it may be subject to.
- Spouse/depen pension - how much on death and examples of how much paid (3)
- death in service pen based on what, if deferred DISLS paid how and usually entitled to what
Death after retirement - what is usually included and e.g. & how much of pension do they get
Scheme rules outline - DIS Bens and who beneficiary is. If expression of wish nominates someone to receive, they are paid at trustees discretion.
Lump sum death benefit - can pay this on death in service of member. Lump sum payable is unlimited but if member dies pre 75 any lump sum in excess of LTA charged at 55%.
Spouse or dependants pension - Can pay unlimited pension to these on death in service and rules outline amount of pension. For example;
- % of pension based on prospective service til NRA
- % of pension accrued on date of death
- fixed % regardless of service (better if joining scheme late)
Death in service pension usually based on member’s pensionable renumeration at date of death. If deferred, DISLS not usually paid although conts can be returned but usually entitled to % of preserved pension revalued at date of death.
Death after retirement - often guaranteed period e.g. bens paid for at least 10 years and would continue to pay beneficiaries on death. Usually a fixed % of pension at date of death.
Benefits on death - life cover - funding rate assumptions and effect and what employer can use to ensure what received
Calc of DB funding rate uses assumptions about amount of members that die before SNRA and if not right then can be costly to scheme. This can have adverse effect on funding rate at next review and significant if scheme is small. Employer may use separate insured death in service scheme to ensure DIS bens are received but no drain on DB fund.
Funding methods and issues - how actuaries work out funding rate (3) and at each review (3), method of valuing liabilities and approaches used for this
Scheme’s actuaries work out funding rate and works;
- actuary makes assumptions to calc projected scheme bens for each member on retirement, death or exit.
- value of these liabilities compared to value of scheme assets and funding rate calc’d
- funding rate reviewed every 3 years as assumptions may not work out as such.
At each review;
- actuary re-calcs assumed cost of bens at retirement taking into account scheme liabilities since last review
- funds held on review date are schemes assets and reflect investment growth since last review
- difference of the two used to calc funding rate for next period.
No single method of valuing scheme’s liabilities. Different approaches & underlying assumptions used for different purposes.
Funding method and issues - Ongoing scheme valuations - Pension Act 04 requires what and what can they do as long as?
Statutory funding objective - must be set for what, scheme funding must meet what, must set what that details what, product what and what put in place if obj not met.
Schedule on conts specifies what and has to occur when
PA 04 requires DB to undertake actuarial valuations yearly but can extend to three years as long as reports in between.
Statutory funding objective must be set for all private sector DB schemes.
- scheme funding must meet amount of assets needed to cover future liabilities.
- must set statement of funding principles which detail how objective will be met.
- must produce periodic valuations and reports.
- recovery plan must be created if not met objectives
Schedule of contributions must be produced which specifies rates on conts from employer and employee and must occur within 15 months of valuations effective date.
Role of trustees - who must they appoint to do what, who does it include (3), how eligible and who not (3), criminal record and docs they must be familiar with (3)
DB schemes must appoint trustee to oversee trust. Usually included director or senior exec, company secretary and accountant. To be eligible for trustee must be able to hold property, those ineligible are;
- minors or insane
- disqualified under Pensions Act 95 (bankrupt or dis director)
- some prohibited by TPR.
Criminal record not disqualifying unless deception or dishonesty.
Trustees must be familiar with documentation such as;
- schemes trusts and deeds
- statement of investment principles
- statement of funding principles
Trustees must have an understanding pension and trust law and sufficient knowledge of the basics of occupational scheme funding and investment.
Trustees Responsibilities - DC scheme trustee responsibilities (5) and specific responsibilities (6)
Responsibilities for DB scheme trustees;
- hold and invest assets to achieve best financial return consistent with security - powers set out in trust deed & used for ben of bens
- maintain scheme in best interest of members and act impartially
- act within provisions of the deed
- know and understand the scheme, its provisions and financial background
- meet knowledge requirements and inform TPR of notifiable events
Specific responsibilities as well which include;
- obtaining audited accounts or face criminal prosecution
- not relying on advice on anyone they haven’t appointed
- draw up schedule of contributions
- obligation to report delays in payment to TPR
- prepare statement of funding principle which outlines how funding objective will be met with methods and assumptions outlined.
- establishing recovery plan if not meeting funding objective
Trustees powers - what does trust deed set out (3), if not on trust deed what applies.
Member nominated trustees - how much of occ scheme and who nominated for trustee and exceptions (4)
Who must trustees appoint (3) and don’t have to when and legal advice and consequences if not
Trust deed sets out powers to;
- hold the scheme assets and apply them
- determine all questions in relation to scheme
- carry out transaction with connection to the scheme
Where trust deed says nothing on a subject, standard trust law applies.
Member nominated trustees - at least 1/3 of trustees of occ scheme must me a member nominated. Exceptions to this include;
- every member is a trustee
- the scheme only has one member
- sole trustee or all trustees are independent
- small insured scheme
Trustees must appoint actuary, auditor and fund manager. Not necessary to appoint fund manager if wholly invested in insurance policies and the other two when arrangement is insured or earmarked. Must only rely on legal advise given by someone they appoint - removal and fined if not.
Duties of scheme actuary - they will (4) and can give advice on (5)
Scheme auditor - must be what (2) and cant be (5) and auditors statement and contributions (explain action +2)
Scheme actuary will;
- prepare periodic actuarial valuation
- provide advice on funding principles, schedule of conts etc
- certify that calc of technical provisions is made in accordance with funding regulations and schedule of conts is consistent with statement of funding objective.
Can give advice on;
- investment strategy and scheme benefit design
- individual factors (transfer values etc)
- pension cost in employer accounts
- pension aspects of sales and purchases
- provision of statutory actuarial certificates
Auditor - must be appointed by trustees and be a registered auditor. Can’t be a member of the scheme, employee of trustees, employer, trustee or connection to trustees. A auditors statement must include option on whether or not contributions have been paid;
- in accordance with schedule of conts
- if they have not must state reasons why
