Increasingly we are seeing companies find the cost of their pension schemes increase as a direct result of action taken by scheme trustees to offer more generous cash commutation terms to members on retirement.

On retirement, members of most pension schemes have the option to convert part of their pension for a cash lump sum, which under current legislation is paid tax-free.  Historically most members have tended to take the maximum amount of tax-free cash available to them on retirement.  This trend has continued following the tax changes introduced on A-Day following which most people have been able to take more cash than previously.

The terms of exchange or commutation factor is expressed as the amount of cash that the member receives for each £1 of pension given up.  The higher the commutation factor, the less pension the member must give up for a fixed amount of cash and hence the higher the residual pension which must be provided by the scheme.  Accordingly, the higher the commutation factor, the higher the cost of providing scheme benefits.  As such it is very important for companies to be aware of the impact of changes to commutation factors. 

Typically the trustees determine the commutation factors but in some cases the actuary sets the rates.  However, as sponsor to the scheme we would expect the company to be consulted about any changes made to the terms offered to members and to have the opportunity to make representation to the trustees, although this doesn’t always happen in practice.

Trustees tend to review the commutation factors periodically, often after each formal triennial actuarial valuation.  The trend in recent years has been for trustees to increase commutation factors as a result of such reviews.  The commonly perceived rationale for doing so is that the old factors did not represent “fair value” to members.  There has been a lot of debate about this issue in the media and within the pensions industry recently.  The following are just two examples of the commonly held view that members are being ripped off despite the fact that cash commutation is not compulsory but just an option available to members:

Pension savers ‘short-changed by £7bn a year’

The Sunday Times, 20 November 2005

"Up to a million people a year take a tax-free lump sum from a final-salary pension scheme, yet in terms of value for money it is probably one of the worst financial decisions they will ever make," says John Lawson, head of pensions policy at Standard Life.

The implication of these types of comments is that members are making irrational decisions and that scheme trustees should increase commutation factors.  However, we have conducted our own research into this matter and considered the cash commutation dichotomy from the viewpoint of the member, the one interested party that most commentators tend to overlook.  We believe that members are correct to take cash at lower levels still offered by some schemes and that increasing commutation factors is generally not necessary.

Our research considers how a member might replicate the cash lump sum option provided by a pension scheme in the open market.  The result is that to do so would prove more expensive than to exchange pension for cash, even using commutation factors that most commentators might perceive as “unfair”.  Furthermore, the cash commutation factors appear “good value” to the member, even before making allowance for the beneficial tax treatment of the lump sum vis-à-vis the pension.  We propose to publish our research in full in due course.

In recent months, several of our clients have successfully utilised the results of our research to make representation to their trustees that has resulted in a further review of the commutation factors.  Most of the clients who have done this have been successful in persuading their trustees not to increase commutation factors or to reverse earlier decisions to increase them.

If you would like further information on this topic or have a specific query please contact or Richard Jones (020) 7533 6967 or Chris Parlour (020) 7533 1815.