Chapter 4 - Defined Benefit Schemes (7 marks) Flashcards
1
Q
Areas that the CII R04 examiner is very keen on include:
The different types of DB schemes
The most common accrual rates
Early leaver options
Death pre-retirement options and benefits
Public sector schemes
A
2
Q
DB schemes cannot access certain pension freedom options, such as FAD and UFPLS, as these apply to DC scheme members. This means that a transfer would be required to use these options.
A
3
Q
there are several different types of DB scheme such as:
Traditional DB
Career average
DC underpin
DB underpin
A
4
Q
What is a DB schemes accrual rate
A
This is the fraction used to determine the rate at which benefits accrue. The lower the fraction, the quicker the benefits will build up. The most common DB accrual rates are 1/60ths and 1/80ths
5
Q
Why is there greater risk for employers with DB schemes?
A
Usually, both employee and employer will pay contributions into the DB scheme. Ultimately, however, it is the employer’s responsibility to ensure that there are sufficient scheme assets to secure Joe’s pension entitlement when he retires.
6
Q
DB schemes can provide a broad range of benefits which can include PCLS, a death in service (DIS) lump sum, payment of dependant pensions, and inflation proofed pension income payment (called escalation)
A
DB schemes do not offer ‘pension freedom’ option of taking benefits as cash, unless under triviality rules.
7
Q
PCLS is also available from DB employer schemes, commonly on a 3/80th accrual basis.
A
With most schemes, taking this cash will reduce the pension income by the use of a commutation factor.
8
Q
There are many ways to calculate the final salary value that is used to calcualte benefits in a DB scheme
A
Some schemes use last 12 months of employment to calculate both pension and PCLS benefits. (salary will likely increase as they progress through their career, so this is quite an expensive way of calculating DB benefits) (This is more traditional)
Some schemes do it as ‘average salary over the last three (or five) years before the scheme normal retirement date (NRD)’.
Some schemes use career average. (least expensive for employers)
9
Q
What is revaluation?
Revaluation is ‘increasing the value of benefits between the year of accrual and the year benefits are paid’. It is a form of inflation-proofing. The rate used will depend on the scheme. It could be linked to an index, such as RPI or CPI, or could be a fixed annual amount, such as 5%.
You have also come across the term ‘escalation’ in pensions previously. This is the inflation-proofing of pension benefits in payment. Remember: as a pensioner, you will probably take the escalator…
A
Revaluation is inflation proofing up to the point of taking benefits
Escalation is inflation proofing once benefits are in payment
10
Q
A career average DB scheme helps a sponsoring employer by:
potentially reducing DB scheme funding costs.
giving the employer the scheme liability for each member year by year.
making costs more transparent year by year. (They cant forsee what the final salary of an employee is, which can be a negative of traditional schemes)
A
If an employer is having funding issues when using a traditional DB scheme, the first option usually considered to help matters is to change the scheme to a career average basis.
11
Q
What are underpinned schemes
A
An ‘underpinned’ scheme simply means that the scheme offers the best of both worlds. It will be based on both DC and DB benefits, and whichever is the highest will be paid at retirement.
DC underpin =
This is a DB scheme, with a DC underpin. The member will receive benefits at the scheme NRD which will be the higher of: Those calculated on the traditional DB basis.
notional DC scheme benefits.
DB underpin =
This is a DC scheme, with a DB underpin.
The member will receive benefits at the scheme NRD which will be the higher of:
Those calculated on a DC fund basis but…
with a minimum level of guaranteed pension, linked to his final salary so…
if required, this minimum will kick in.
12
Q
Usually, the sponsoring employer decides which type of DB scheme to offer to employees. Of all the types available, the most common are traditional and career average schemes.
A
13
Q
Scheme basis
When a DB scheme is established, it could be set up under the framework of a master trust or trust-based.
A
A master trust, with trustees, is a tax-efficient and cost-effective way for an employer to establish a DB scheme for the benefit of all employees. It places scheme assets in trust, under the control of appointed trustees. A master trust must be authorised by TPR.
A master trust is one that has separate sections established for different employers and pension schemes. It is therefore more cost efficient than establishing a full trust-based scheme, where the employer appoints (and pays for) their own board of trustees. It is, however, a less ‘bespoke’ method.
14
Q
NPA is also known as normal retirement date – NRD
A
The scheme must define a retirement date which can also be known as normal pension age or normal retirement age. Up to this point the member will usually pay contributions (unless the scheme is non-contributory) and then crystallise their benefits.
The current minimum age for crystallising benefits for an individual in ‘normal’ health is 55. DB schemes can set their retirement age later than this minimum. This is the norm, with common NRDs being 60 or now 65 with the introduction of state pension age equalisation.
A scheme cannot have a different NRD for men and women
15
Q
DB scheme benefits are based on three factors:
Service period
Final salary
Accrual Rate
A
16
Q
Final salary is also known as pensionable remuneration.
A
This is most commonly a member’s basic salary Only, but other earnings, such as overtime, bonuses, and the monetary value of P11D benefits, could also be pensionable. This is rare in practice, due to the increased benefit levels it produces.
The definition is more likely to be something like ‘a member’s final salary in the last twelve months to retirement’, or ‘the average of the previous three / five years’ final salary leading up to scheme NRD’
IMPORTANT: For the exam, please use the last 12 months as your final salary definition.
17
Q
For the exam, please use the last 12 months as your final salary definition!!!!!!!!
A
The easier one when compared to career average
18
Q
So, who pays what into a DB scheme?
Employer contributions
We discussed earlier that the employer bears the bulk of the risk relating to the funding of a DB scheme as, ultimately, scheme funding is their responsibility. This is known as an ‘open cheque book’ approach.
Contributions are calculated to provide the guaranteed benefits on death or retirement, based on service and final salary. This is an open-ended commitment as it is dependent on many factors.
These factors include:
A
The employer will usually contribute into the scheme at least on an annual basis.
Scheme funding will be reviewed, using the skills of a scheme actuary, to try and ensure the scheme stays on track. This will establish required contribution levels and is known as the scheme funding rate review.
Scheme funding rates must be checked at least every 3 years.
19
Q
DB Scheme funding rates must be checked at least every 3 years by the scheme actuary.
A
20
Q
Member contributions into DB schemes
Although scheme funding is the employer’s responsibility, most if not all, will expect employee contributions. Historically, there were DB schemes that were non-contributory. These are now rare, due to the rising costs of providing such a scheme for employees.
Some employers also provide income protection insurance for members as a benefit, to cover them if they are ill during their working life. Income from this source is classed as pensionable earnings, which means that membership of the scheme can continue if the individual is off sick.
Usually, an employee contribution is set as a percentage of salary, is levied at this set percentage, is applied to the member’s pensionable salary (normally basic salary only) and remains constant.
One of the benefits of an RPS, is the tax perks that encourage both employer and member contributions.
One such benefit is tax relief on both employer and member contributions. Remember, a DB scheme can use either the net pay or relief at source method. In practice, most utilise the net pay method (and this is your assumption for the exam).
A
Employer contributions are unlimited and paid gross
Subject to the ‘wholly & exclusively’ rules
21
Q
Different roles/members in a DB scheme
You are pretty much guaranteed to get at least one exam question on this next topic (Covered in chapter 3)
A
22
Q
Tell me the responsibilities of the following roles:
Trustees
Scheme Adminstrators
Scheme Actuary
Scheme Auditor
A
Important roles to remember: SEE ACTIVITY 4.1
Trustees = Hold scheme assets, report delays more than 30days of contributions to TPR a
23
Q
Role of DB trustees
Trustees of a DB scheme have both general and specific scheme responsibilities. General responsibilities have already been covered back in Chapter 3 of this study guide.
Specific DB scheme responsibilities INCLUDE:
A
DB trustees can delegate responsibilities to third parties (they still have ultimate responsibility)
24
Q
Member nominated trustees (MNT)
The Pensions Act 1995 introduced many new DB scheme safeguards. It came on the back of the Mirror Group pension scheme scandal previously mentioned in this guide.
One of these safeguards was the right of members to elect one third of scheme trustees, with a minimum of two seats, or one seat if the scheme has fewer than 100 members, to better represent their interests.
Also, under the Pensions Act 1995, scheme trustees are required to formally appoint professional advisers which include an actuary, auditor, and fund manager. We will consider these roles next in this section.
A
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Scheme auditor
A DB scheme auditor cannot be:
A scheme member.
An employee of the scheme trustees.
The scheme employer.
A scheme trustee.
Connected in any way to scheme trustees.
They audit the scheme valuations and reports and must be independent of all other parties, with no vested interests. An auditor’s statement contains their opinion as to whether contributions have been paid in line with the scheme schedule and, if not,
why not.
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Scheme investment manager
A scheme investment manager invests scheme assets in line with the statement of investment principles, scheme, and trust deed rules. They can either be an employee or an external individual or company. They are the only one, of the roles that we have mentioned, who are FCA approved and registered
27
28
Benefits from a DB scheme are twofold: a scheme pension income for life and a PCLS.
29
Contracting out
Historically, many DB schemes contracted members out of earnings-related state pensions, such as SERPS and S2P. The member had no choice, if they joined a contracted out DB scheme.
What was a contracted out DB scheme?
This was where the member ‘gave up’ their rights to earnings-related state pensions, such as SERPS and S2P, in exchange for contracted out benefits from their DB scheme. Both employer and employee class 1 NIC contributions were reduced as result of this contracting out election.
Contracted out benefits in a DB scheme were split into two types, depending on the employee’s scheme membership period:
GMP accrual (for service between 06/04/78 - 05/04/97)
Requisite benefits (for service between 06/04/97 - 05/04/2016)
GMP =
GMP stands for Guaranteed Minimum Pension. It was so called because each contracted out member could not be worse off than if they had stayed in the earnings-related state pension.
The pension that the contracted out DB scheme provided had to be at least equal to the state earnings-related element. This was a highly prized element.
Requisite benefits =
From the 6th April 1997, DB contracted out benefits changed from GMP to requisite benefits. This meant that the scheme had to provide benefits broadly equivalent to, or better than, a ‘reference scheme’.
30
Contracted out DB schemes did sometimes buy their members back into earnings-related state pensions. This was known as an equivalent payment or pension. If you see the term ‘equivalent payment or pension’ this relates to state pensions.
31
A DB scheme can also pay a bridging pension. This is also known as an integrated scheme.
Bridging pension
This is where a scheme’s NPA is earlier than state pension age, such as an NPA of 60 and an SPA of 65.
The scheme pays a higher scheme pension for a temporary period to ‘bridge the gap’ whilst waiting for the state pension to kick in. The scheme pension reduces when the state pension starts to be paid. This can also be called an integrated pension.
32
Look at 4.3.2: Benefits at NPA
33
Look at 4.3.2: Benefits at NPA
34
Pension increase exchange (PIE)
Some DB schemes offer the member the choice of taking a higher initial scheme pension in exchange for giving up some of the annual inflation increases on offer. This is an attractive option for a DB scheme, as the costs of inflation-proofing are unknown year on year. Also, increased member longevity has led to spiralling costs.
The employer offers the member a higher pension each year, which may end up being lower than the level the escalated pension could have grown to over the years.
35
Pension increase exchange (PIE)
Some DB schemes offer the member the choice of taking a higher initial scheme pension in exchange for giving up some of the annual inflation increases on offer. This is an attractive option for a DB scheme, as the costs of inflation-proofing are unknown year on year. Also, increased member longevity has led to spiralling costs.
The employer offers the member a higher pension each year, which may end up being lower than the level the escalated pension could have grown to over the years.
36
A member of a DB scheme can also accrue a Pension Commencement Lump Sum (PCLS) in addition to their scheme pension. We will consider this benefit type next
LOOK AT EXAMPLE 4.10 as there are 3 calculations to remember.
37
For DB schemes the PCLS must be paid within an 18-month period which is up to 6 months before and 12 months after the member becomes entitled to the associated scheme pension. Otherwise, it will be classed as an unauthorised payment and taxed accordingly.
38
PCLS must be paid within an 18-month period which is up to 6 months before and 12 months after the member becomes entitled to the associated scheme pension. Otherwise, it will be classed as an unauthorised payment and taxed accordingly.
39
Look at PCLS section. It has mulitple calcs and the formula that must be used to calculate PCLS figure and how to find out if more than 25% is used
IMPORTANT
Also find out how to calculate accrual rate if it is not given
40
Early retirement
HMRC rules allow an individual in ‘normal’ health to crystallise DB benefits from age
55+. Most DB schemes have an NPA of between age 60 and 65. If the individual wishes to crystallise earlier they are likely to:
need trustee permission (scheme rules must allow early retirement).
suffer an early retirement reduction in scheme benefits.
Penalties for early retirement can be substantial. They are usually expressed as a percentage reduction in benefits available for each year crystallised early. On top of this, the member will have less pensionable service.
This can lead to large reductions in total benefits payable and make early retirement non-viable. So, although early retirement is an option, many members cannot afford the associated reduction in benefits.
41
Ill-health retirement prior to age 55 is permitted if scheme rules allow this. The member is simply crystallising benefits earlier than age 55 without these being classed as unauthorised payments; so, a scheme pension and PCLS.
42
Serious ill-health commutation of benefits is only permitted if the member has life expectancy of less than one year. It involves commuting all benefits as a cash lump sum, but only if scheme rules permit this option.
For such payments to be made, the individual must:
have less than 12 months life expectancy.
provide health evidence to substantiate this, from an RMP, prior to any payments being made, to ensure these are not classed as unauthorised.
Serious ill-health retirement is an RBCE pre age 75, so there will be an LSDBA test. If the lump sum falls within the LSDBA, there will be no tax due. Any excess will be charged at the member’s marginal income tax rate. If the individual is aged 75 or over, all the lump sum paid will be taxed at the member’s marginal income tax rate.
43
Look at comparison table to see different between taking DB benefits due to ill health and serious ill
Health (less tban 12 months)
44
Benefits from a DB scheme are twofold: a scheme pension income for life and a PCLS.
45
Additional voluntary contributions (AVCs)
This top-up arrangement was offered by the scheme itself, otherwise known as ‘in house’ AVCs. There were two main types of AVC available:
Added years.
Defined contribution.
Added years
These work exactly as they sound. The member paid extra contributions (which could be matched by the employer) and, as a result, purchased extra years in their scheme. They were buying extra 1/60ths or 1/80ths, depending on their scheme accrual rate. This had the effect of producing higher guaranteed benefits at retirement, which could include not just a higher pension, but also higher PCLS and dependant benefits.Members paid additional contributions expressed as a percentage of their salary. Some schemes did not allow these increases to stop, once they had started, unless the member experienced financial difficulties. Often the employer would also match any additional employee contributions. As AVC benefits were part of the main scheme, the member could only crystallise them at the same time as the main scheme benefits
Defined contribution
DC AVCs invest additional member contributions (which could be matched by the employer) into a DC fund.
This means that ‘additional’ benefits at retirement are dependent on annuity rates and market conditions.
These benefits can be crystallised at the same time as the main DB scheme, or earlier or later, depending on scheme rules. At NPA, these funds could be used to purchase an additional pension for the member. Alternatively, some schemes allow the member to use this DC fund to provide their PCLS, leaving the main scheme free to provide solely a guaranteed scheme pension at retirement.
This can be beneficial, as a scheme pension will escalate in payment. So, by using DC AVCs to provide PCLS, the member will receive a higher scheme pension from the main scheme (as none has had to be commuted for cash) which must go up each year in line with set minimums.
DC AVCs again have both advantages and disadvantages.
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Free Standing Additional Voluntary Contributions (FSAVCs)
These were available from insurance companies and were not part of the main DB scheme. This meant that the member effectively had the choice of the market in terms of provider and could also select funds in line with their own personal preferences and risk attitude. The downside is that extra funds were accrued on a DC basis, so could go down in value as well as up. Also, any charges had to be met by the individual, with no employer subsidy. Whereas an employer may well have matched higher employee contributions into an AVC, this was not likely to be the case with an FSAVC.
47
What are Public-sector schemes?
exactly as they sound. They are DB occupational pension schemes, offered to individuals who work within the public sector. (Their employer is the state)
Public-sector schemes include the civil service, local government, teachers, the NHS scheme, the police force, the fire service, and the armed forces. There are differences between the different types of schemes in this category, but we will concentrate on their common features, which include:
Pension built up on career average basis
Escalation and revaluation in line with CPI
Some of these features have only been recently introduced by the government, in a bid to try and reduce the cost of public schemes. . Any member within 10 years of their scheme NRD as at 1st April 2012 retained the old features that used to be in place such as 1/80th pension accrual with 3/80ths for tax-free cash.
48
In relation to public sector schemes, there are three types of funding status:
Funded schemes
Notionally-funded schemes
Unfunded schemes
Tell me each. note Funding of these schemes is partly by member contributions but heavily from the public purse. As life expectancy has increased, the costs of these schemes have spiralled, hence the need to reduce benefits
There are three types of funding status:
Funded schemes are where contributions have been invested into scheme assets to build up member benefits. There are not many of these! One example is the Local Government Pension Scheme (LGPS).
Notionally-funded schemes again sound like what they are. There are some scheme assets, but not many, with most contributions deemed to have been invested in Government securities (Gilts). These scheme types depend heavily on additional government funding. Examples of notionally-funded schemes include the NHS and Teachers’ Pension Scheme (TPS).
Unfunded schemes have no scheme assets at all! An example of this is the civil service scheme. So, the state meets any scheme payments as they become due.
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Regulation of public sector schemes
TPR are responsible for the regulation of these schemes. There is a Code of Practice for Local Government, Civil Service, Armed Forces, Police, Fire Service, and Judicial schemes from April 2015.
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What is The Transfer Club in relation to public sector schemes
Membership of the transfer club is available to members of public-sector schemes.
Its main advantage is ‘beneficial actuarial treatment’ on any transfers between club schemes.
The overall effect is that, when the member who has been in different public-sector schemes throughout their working life reaches their NPA, it is as if all their service was in their last DB pension scheme. There are no reductions due to any transfers.
This is not the case in the private sector, when a member will rarely receive the same number of years built up in their ‘old’ scheme, in any new DB scheme that they have transferred their benefits into.
The essential point with the Transfer Club is that members can transfer benefits between schemes with no loss of benefits.!!!
Changes to public-sector transfers
As a result of the flexible pension options introduced from 2015, some changes have been made to public-sector transfers.
The Pensions Act 2015 introduced new legislation, which allows the government to reduce the value of a CETV paid to a member of certain public-sector schemes. This reduction can be exercised in situations where such a transfer would significantly increase the risk required, or level of public funds needed, to support the pension scheme in meeting its liabilities.
This new rule mainly applies to funded public-sector schemes, and brings these scheme types in line with the private sector in this regard.
The transfer situation with notionally-unfunded and unfunded schemes is significantly clearer. A member cannot transfer benefits from an unfunded public-sector scheme to access flexible pension options, as a CETV will not be paid. Such notionally-unfunded and unfunded schemes include the NHS scheme, teachers, and civil service schemes.
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The essential point with the Transfer Club is that members can transfer benefits between schemes with no loss of benefits.
The transfer club only works for funded schemes
The transfer situation with notionally-unfunded and unfunded schemes is significantly clearer. A member cannot transfer benefits from an unfunded public-sector scheme to access flexible pension options, as a CETV will not be paid. Such notionally-unfunded and unfunded schemes include the NHS scheme, teachers, and civil service schemes.
LOOK AT EXAMPLE 4.17
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A DB scheme provides each member with guaranteed benefits, as we have discussed. These guarantees are underwritten by the scheme’s sponsoring employer, who therefore needs to ensure there are sufficient assets in the scheme and enough is being paid by way of contributions.
4.5.1: Statutory funding objective
A DB scheme must satisfy its statutory funding objective (SFO). This requirement applies to all DB schemes. Schemes must have enough assets to meet their technical provisions.
In plain English, this means a DB scheme must have enough assets to meet all its liabilities.
53
4.5.1: Statutory funding objective
A DB scheme must satisfy its statutory funding objective (SFO). This requirement applies to all DB schemes. Schemes must have enough assets to meet their technical provisions.
In plain English, this means a DB scheme must have enough assets to meet all its liabilities.
In terms of liabilities, this equates to the concept that, if all scheme benefits had to be paid in one go, would the scheme have enough assets? The statutory funding objective is a generic, high-level objective and contains no detail on how a scheme will achieve this.
The lower level of detail on how this objective will be achieved is contained in two documents that provide all the detail regarding the scheme rules, and how it will ensure the SFO is met. So, DB scheme funding documentation is contained across two tiers:
The SFO is contained in the:
The Statement of funding Principles
&
The statement of investment principles
(Both are drawn up by the scheme trustees with input from the scheme actuary and sponsoring employer.)
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Statements of funding and investment principles
Statement of funding principles
This contains a variety of different rules and standards, including: SEE 4.5.2
Statement of investment principles
This contains a variety of different rules and standards, including:
55
What is the scheme funding rate review?
Scheme actuary requirements
With regard to a DB scheme, funding safeguards are put into place. These involve the scheme actuary calculating the required scheme contribution levels at least every 3 years. This process establishes the scheme funding rate and is known as a scheme funding rate review.
Two assumptions are key in this process:
Annuity rates affect how much capital is needed in the future to buy out member scheme pension benefits.
Discounting rates affect how much the scheme requires in today’s terms to meet its technical provisions.
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DB scheme valuation
The types of valuation are:
Ongoing, International Accounting Standards (IAS) 19, PPF Section 179, insolvency/PPF section 143
Tell me about each (they are whta the scheme actuary does to valuate a scheme to see if any deficit or not against SFO. Trustees can then issue recovery plans if there is a deficit
Ongoing valuations
These must be carried out at regular intervals, to ensure the scheme SFO is met.
Remember: a scheme must have sufficient and appropriate assets to cover its technical provisions.To ensure this is the case, certain minimum standards must be followed, including:
Valuing scheme assets at their market value.
Producing periodic actuarial valuations and reports.
Producing a contribution schedule within 15 months of the valuation’s effective date.
Keeping members informed of the scheme funding position.
Drawing up a recovery plan, if the SFO has not been met.
International Accounting Standards (IAS) 19 valuation (most key for the R04 exam)
IAS 19 was established with the aim of making the costs of running and funding a DB scheme more transparent. This basis is applied to ongoing schemes being run for the benefit of members.
Some of the key changes it introduced are:
Any surplus or deficit must be shown on the company’s balance sheet.
As many companies offering a DB scheme are limited companies or PLCs, a deficit will have an impact on a company’s share price. This will affect both company sales and mergers. Surpluses are rare, but there are still schemes that have had greater assets than their liabilities. If a scheme is in surplus, this surplus could be used to enhance member benefits, allow the employer / employee to take a contribution holiday or be returned to the employer less 35% tax.
Scheme assets must be shown at market value.
Scheme liabilities must be calculated using a discounting rate based on AA corporate bond yields.
This assumption effectively means that liabilities are likely to be stated as higher than if other calculation assumptions were made. This, in turn, makes it more likely that the scheme will be in deficit and, as mentioned above, this deficit will be shown on its balance sheet. These factors are likely to be out of kilter with actual scheme assets which tend to be heavily equity-invested.
It is no wonder that so many employers have replaced their DB schemes with a DC version going forward, due partly to the changes brought about through IAS 19.
]
Discounting Rate: The discounting rate is a percentage used to determine the present value of future cash flows. Since these liabilities will be paid out over many years, they need to be adjusted to reflect their value today. The further in the future the payment is expected, the less it is worth in today's terms due to factors like inflation and investment risk.
AA Corporate Bonds: AA-rated corporate bonds are issued by companies that have a strong credit rating, indicating a low risk of default. Using yields from these bonds as a benchmark for the discounting rate provides a conservative and stable measure, reflecting the returns that a pension scheme could expect to earn on its investments with a similar risk profile.
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Section 179 valuation
A section 179 valuation is used with ‘live’ ongoing schemes, to establish the level of scheme-based risk levy paid by a DB scheme on an annual basis to the PPF.
It is similar to a 143 valuation (covered below) but a simpler asset and liabilities valuation basis is used.
It looks at current scheme assets and liabilities, but in the context of payment of member benefits in line with current PPF compensation levels, considering the assets required if the scheme were entering the PPF.
It takes into account:
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Insolvency valuation
This is a valuation carried out by the actuary that assumes a scheme is coming to a close due to the insolvency of the sponsoring employer
This would be likely to involve the PPF (if the scheme is eligible) therefore this type of valuation is also known as a PPF Section 143 valuation. The valuation is carried out in line with prescribed standards issued by the PPF.
Remember, the PPF is the organisation that steps in and provides financial assistance to underfunded DB schemes to provide members with some minimum scheme benefits where the employer becomes insolvent from 6th April 2005.
What is the starting point of an insolvency valuation?
This starts with the costs of buying out member benefits with an insurance company. Again, prescribed rules must be followed, including: SEE IMAGE
Revaluation and escalation and discount rates used are based on long-term index-linked gilt yields. For escalation, either index-linked or conventional gilt yields can be used.
If a scheme is shown to be in deficit following an actuarial valuation, then the trustees must put into place a recovery plan to remedy the situation.
This recovery plan must follow the scheme guidelines set out in the statement of funding principles and be submitted to TPR.
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DB scheme recovery plan
A recovery plan must set out some key scheme requirements which include: SEE IMAGE
ALSO,
Trustees must consider a range of factors when putting a recovery plan together.
These relate to:
A recovery plan must address any scheme funding shortfall but should also ensure the sponsoring employer is not adversely affected in terms of growth and investment plans.
The last thing TPR wants, is an unrealistic recovery plan, leading to employer insolvency and the scheme approaching PPF for compensation. That is what it is trying to avoid!
Excessive risks must be avoided. The key term to be applied is ‘balance’. Now there’s an interesting generic word with no clear rules on what that actually means (!).
If a scheme is underfunded, there are several different options available to trustees (some of these would be classed as significant changes), such as: changing the schemes NRD or increasing contributions etc
Do the employer / scheme trustees need to consult with members?
Yes, if the changes made are classed as ‘significant’. This is a legal requirement if there are more than 50 employees, but is viewed as best practice for all employers. This consultation must follow a set process:...
One of the responsibilities of the scheme trustees in this process is to ensure that all employees have been consulted and that the above process has been followed, before agreeing to any scheme changes.
If an employer fails to follow these rules and standards, a maximum £50,000 TPR fine can be imposed.
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DB Schemes White Paper
In 2017, the DWP issued a Green Paper entitled Security and Sustainability in DB pension schemes. This paper considered the huge challenges in funding that DB schemes were facing due to issues such as the stock market crash of 2008, low interest and annuity rates. These challenges meant that most DB schemes found themselves in a deficit and recovery plan situation. The White Paper proposals issued in 2018 showed that, on the whole, DB schemes were coping well.
It did however recommend a tougher approach to any schemes that were not acting responsibly. These proposals included:
Strengthening TPR powers: giving TPR the ability to levy larger fines and introducing a new ‘criminal offence relating to ‘reckless behaviour’. TPR also now have stronger powers in relation to information-gathering and inspections.
Improving DB scheme funding: ensuring that schemes take a longer-term view, rather than just for the next three years. Trustees will need to appoint a new Chair, who will report to TPR the key scheme funding decisions, alongside triennial review information.
Consolidation – assets / liabilities and administrative functions could be pooled leading to greater scheme efficiencies. The Pension SuperFund is the UK’s first consolidating pension ‘superfund’. It accepts bulk transfers from existing DB pension schemes and pools them together to create one large occupational pension scheme. Through the benefit of advantages of scale, they aim to achieve higher returns with lower costs, greater stability and less risk which is obviously good news for employers, members and trustees. In addition to the Pension SuperFund, Clara Pensions now also offer a DB pension superfund option.
The government’s Pensions Scheme Act 2021, contains some interesting (!) rules in relation to DB scheme funding. We will consider these next to ‘round off’ this section.
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Pensions Schemes Act 2021
Trustees of a DB scheme, under these new rules, will have to
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What is a termination clause?
The rules of a DB scheme must include the option to wind a scheme up. They must also show the circumstances in which this option can be utilised by a scheme. This is known as a termination clause.
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the likelihood of a DB scheme having a scheme surplus is slim, as it means the scheme has more assets than it requires to meet its technical provisions. If one does exist, it could be used to enhance member benefits, allow both employer and member to take a contribution holiday or be refunded to the sponsoring employer.
For a surplus to be refunded to an employer, the employer must request this option and the scheme trustees must agree to it.
Any surplus payment will be subject to several key conditions, including:
Confirmation from the scheme actuary that the scheme is funded above full buy-out level
This means that there are more than enough scheme assets to fully buy out all member benefits with an insurance company.
Informing all members in writing
Any refund to a sponsoring employer must be notified, in writing, to all scheme members.
Taxing the surplus at a flat 35% rate.
Notifying TPR once the payment is made
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Closing a DB scheme
If an employer selects this option, they will be faced with a couple of options:
-Making the scheme paid-up
-Closing the scheme to new members but retaining existing member benefits
If a scheme is made paid-up this means two things: no new members can join, and no further benefits can be accrued.
Closing the scheme means no new members can join, but existing members keep, and continue to accrue, their benefits.
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many employers have replaced their DB schemes with a DC option.
An employer usually takes one of two approaches:
Fully winding-up a DB scheme
Closing a DB scheme to new members
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Benefits within an RPS are now split into two transfer definitions:
Flexible benefits are those in DC or cash-balance schemes. So effectively, any types of schemes where benefits relate to a fund value.
Safeguarded benefits are those that contain either guarantees or some element of protection. (DB schemes)
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There are several options that may be available to an early leaver of a DB scheme, depending on the length of time they have been a scheme member. These are:
Refund of personal contributions
( member must have less than two years’ service in the scheme. This is known as a short-service refund. The scheme is under no obligation to offer this option, Only the member’s contributions are refunded, not the employers. A short-service refund is taxed in a set way:The first £20,000 is taxed at 20%
Any excess is taxed at 50%)
Leaving scheme benefits preserved
ption for a scheme member, if they have two or more years’ service in a DB scheme, and the scheme rules permit this option. Most schemes offer this option. This option is commonly known as a short-service benefit. The individual who has left their scheme benefits preserved is known as a deferred member (remember, active members are those who are in the scheme, and still working for the employer).The scheme will calculate the preserved benefits in the usual way, using the member’s service, final salary, and scheme accrual rate, but as at date of leaving, rather than scheme NRD.These benefits will then be entitled to a degree of revaluation.
What is revaluation?
Revaluation is inflation-proofing benefits between the individual’s date of leaving and the DB scheme NRD.
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Revaluation increases are applied either when benefits are taken or transferred. The average rate across the years is used from not each year in isolation
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You can see above that revaluation rates are identical to escalation rates previously covered in this chapter. The key difference is the pivotal year when rates fell from CPI capped at 5% to 2.5%.
For escalation this is 2005.
For revaluation this is 2009.
Way to remember what was first and second: The world was escalating into a financial crash in 2008. After 2008 when it happened they revalued themselves
Remember, revaluation is inflation-proofing between the date the member leaves the DB scheme with benefits preserved and the scheme’s NPA. If benefits are transferred into a DC RPS, they become ordinary DC rights and all revaluation requirements are lost.
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If the scheme is underfunded, the scheme trustees may decide to offer a lower CETV.
This is to ensure that members who remain in an underfunded scheme are not disadvantaged by the scheme payment of a CETV based on a ‘best estimate’ ICE figure.
However, trustees can only reduce CETVs for this reason, after obtaining an assessment by the actuary of the funding of the scheme, using transfer value assumptions. This is known as an 'insufficiency report'.
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Rather than reducing CETVs, some schemes actively encourage members to transfer, by offering enhanced transfer values.
If a member transfers their benefits out of a DB scheme this reduces a scheme’s liabilities. This means that some schemes offer enhanced transfer values to provide an incentive for members to transfer their benefits into another RPS. These enhanced transfer values are usually offered for a limited time, commonly for a three-month period. If the member does not make their decision within these timeframes, their CETV will usually revert back to the standard calculation terms.
Rules for this.
Schemes should avoid of offering cash incentives
Members should take professional financial advice
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Transferring safeguarded benefits
An individual must obtain independent advice if they are considering a transfer of more than £30,000:
into a different RPS
into a different part of their existing scheme
to gain access to flexible benefits
So, what types of benefits are classed as safeguarded?
This term relates to any benefits that have guarantees or protection within them, as mentioned previously in this chapter. These include: Defined benefit schemes, Section 32 buyout bonds with a guaranteed minimum pension, Retirement annuity contracts (with a guaranteed Annuity Rate (GAR)
f the CETV is £30,000 OR LESS, independent advice is not required (though some form of advice would be strongly recommended to anyone considering a DB transfer).
This requirement has been introduced by the Pensions Act 2015.
Such advice must be given by an authorised independent financial adviser and checked by a pension transfer specialist (PTS).
These requirements have also led to greater responsibilities for DB scheme trustees. The ceding scheme trustees must see evidence that the member has received advice, before a CETV transfer can take place.
They do not have to know if the member took the advice or indeed what the advice itself was.
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So how does a member decide if a transfer is the best option for them?
DB pension transfers have historically used a process known as the Transfer Value Analysis System or TVAS to produce a TVA or Transfer Value Analysis. This was a legal requirement since 1 July 1994.
Transfer Value Analysis System (TVAS)
A TVA report was produced, which compared the guaranteed benefits that the member was giving up in their DB scheme, to those that could be provided from the RPS they wished to pay their CETV into.
It was a report that produced many facts and figures. The key figure was known as the ‘critical yield’.
A critical yield showed the annual net investment growth required, from the new DC scheme, to at least match the guaranteed benefits the member was considering giving up in their DB scheme.
The higher the annual critical yield required, the less likely it was to be a good idea to transfer the CETV.
REMEMBER ALSO Many of the pension flexible options are not available for a DB scheme member, so the temptation to transfer to access these is likely to be great so they can gain access to the flexibility options
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Do activity 4.5
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As already mentioned, the member must take independent advice if:
they are transferring safeguarded benefits.
with a CETV of more than £30,000.
this advice must be given or checked by a pension transfer specialist.
Independent being an advisor which is independent to the scheme, not necessarily and IFA
Trustees now cannot pay out a CETV to a receiving scheme if they do not have written evidence that this advice has been given, signed by the financial adviser. This written evidence must contain the following confirmation:
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Scheme trustees must complete transfers within set statutory deadlines of six months currently.
They can, in certain circumstances, apply to TPR for an extension to these timeframes. The request must be made during this six-month period. TPR is likely to grant such an extension where:
A DB scheme is being wound-up.
The member has not satisfied all the required transfer steps.
Scheme trustees fear the member will be disadvantaged.
Scheme trustees have not received all the required information.
The CETV is being disputed.
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A new process was introduced in October 2018, called an appropriate pension transfer analysis or APTA. The details are now included in the FCA’s policy statement and COBS. This process uses a prescribed comparator known as a transfer value comparator or TVC.
Let’s consider these next.
Appropriate pension transfer analysis (APTA)
The aim of any DB transfer process must be to show why the recommendation is suitable for the client.
APTA considers not just a financial analysis but also non-financial and behavioural factors and analysis. To produce an APTA a firm must:
Assess ceding DB scheme benefits and options.
Assess benefits and options under the proposed new DC scheme.
Produce a comparison of the two.
Include risk factors such as:
risk of remaining in and transferring out of the scheme.
requirement for and risks of flexible benefits.
cost and tolerance of ongoing advice costs.
investment experience.
All charges must be considered except for where adviser charges are paid by a third party (such as an employer) and charges that would be payable that are not reliant on the transfer going ahead.
Charges considered will therefore include product, platform and adviser.
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What is triage?
A non advised service/process. It does not involve giving advice
READ 4.7
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Transfer from the UK to an overseas scheme
The key factor in the treatment of this transfer, is the type of overseas scheme the CETV is being paid to.
If the receiving scheme is a QROPS / ROPS, it will be classed as a recognised transfer.
If the receiving scheme is not a QROPS / ROPS, it will be classed as an unauthorised payment.
We need to consider both and the effects on the individual.
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Transfer from a UK RPS to a QROPS / ROPS
(As this transfer is classed as recognised, this is an authorised payment. As such, it does not give rise to unauthorised payment taxation (thank goodness))
A QROPS / ROPS must be broadly equivalent to a UK RPS. This means the member must be able to receive a cash lump sum and income at retirement. Just because the member wishes to transfer, this does not mean the QROPS / ROPS will automatically accept such a payment. This will depend on the QROPS / ROPS rules, plus the laws of the country is it established in.
Certain details must be divulged to the ceding scheme administrator. This is because, as already covered, a QROPS / ROPS transfer is an RBCE, and must satisfy certain HMRC rules in its first ten years.
If the transfer breaches the Overseas Transfer Allowance (£1,073,100 for most), the excess will be taxed at 25%.
A separate 25% tax charge (Overseas Transfer Charge) will apply unless at least one of the following exclusions applies:
The member is resident in the same country as the QROPS is based in.
The QROPS is in the EEA / Gibraltar, and the member is UK resident / resident in a country within the EEA or Gibraltar.
The QROPS is either an occupational scheme or an overseas public service pension scheme, with the member joining as an employee.
The QROPS is set up by an international organisation, to provide benefits for current or former employees of that organisation.
LOOK AT EXAMPLE 4.25!!!
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Transfers from a UK RPS to a non QROPS / ROPS overseas pension scheme
These are transfers from a UK RPS to an overseas scheme that is not classed as a QROPS / ROPS.
This type of transfer will be unauthorised and will give rise to unauthorised payment taxation.
These charges could include:
Unauthorised payment charge, at a 40% rate, paid by the individual.
Unauthorised payment surcharge, at an additional 15% rate, paid by the individual.
A scheme sanction charge, at a 15% rate, paid by the ceding scheme.
In some cases, a scheme administrator may refuse to pay a transfer if it will give rise to a scheme sanction charge. Remember, if an RPS pays too many unauthorised payments it may end up losing its RPS status, and all the tax benefits that go with it. No scheme wants that to happen.
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Transfers from abroad to a UK RPS
There are three main options open to an individual in these circumstances: Transfers of recognised overseas pension scheme benefits to a UK RPS, Transfers of non-recognised overseas pension scheme benefits to a UK RPS
NOTE: Treatment of any overseas transfers depends, primarily, on whether the ceding scheme is a recognised overseas pension scheme or not.
Transfers of recognised overseas pension scheme benefits to a UK RPS
This is not classed as a recognised transfer. It is not, however, classed as an unauthorised payment either, which is good news for the individual, as they, and the scheme, will avoid the horrors that is unauthorised payment taxation! Again, for your R04 exam, only the basics are likely to be tested. An LSDBA enhancement is given to the individual, as they have not received any UK tax advantages so far. This enhancement factor does not provide any additional tax-free cash for the member, so the LSA is unaffected.
Transfers of non-recognised overseas pension scheme benefits to a UK RPS
These transfers have the same rules as for recognised overseas pension benefit transfers, with one exception: there is no LSDBA enhancement available.
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look at summary of 4.7
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We have looked at the following areas:
1: Setting up a DB scheme
There are several different scheme types, the most common being traditional and career average.
Traditional scheme benefits are based on service, scheme accrual rate, and final salary.
The main share of the risk associated with DB schemes sits with the sponsoring employer.
Career average schemes reduce funding costs and give an idea of costs year by year.
Setting up a scheme involves several key areas, which include: scheme NRD, eligibility, scheme definitions, employer / member contribution rates, and contracting in or out decisions (up to 2016).
DB schemes are usually trust-based and involve different parties: standard and member nominated trustees, administrator, actuary, auditor, and investment manager.
This starts to cover the syllabus learning points:
4.1. Describe the main types, attributes and benefits of DB pension provision including the rules and operation of DB schemes
4.3. Explain the role and duties of trustees and administrators of pension schemes
4.6. Explain eligibility and top-up options
2: The benefits provided
Contracted out benefits, historically, can include GMP and Requisite Test benefits (also known as Reference Scheme or post-97 contracted out benefits).
A scheme pension is payable for life.
Pension increase exchange (giving up some future increases) is governed by set TPR principles.
Taking PCLS usually reduces any scheme pension paid, through use of a cash commutation factor.
A DIS lump sum and/or a dependant pension can be paid.
Ill and serious ill-health benefits are available, if certain conditions are satisfied.
A DB scheme can be topped up by either / both AVCs or FSAVC, AVCs can be added-years or DC basis.
This continues to cover the syllabus learning points:
4.1: Describe the main types, attributes and benefits of DB pension provision including the rules and operation of DB schemes
4.6. Explain eligibility and top-up options
This covers syllabus learning point:
4.5. Explain the benefits available on ill-health and death
3: Public-sector schemes
Public-sector schemes relate to occupations such as teachers, the civil service, the armed forces, and the fire service.
These schemes are provided by the government and local authorities.
They have common features, but also some differences!
Generous benefits are provided in terms in inflation-proofing, early retirement, and application of the transfer club.
New members now accrue benefits on a career average basis, have less-favourable revaluation, and an increased scheme NPA, in line with SPA changes.
Certain public-sector schemes (unfunded and notionally funded) cannot transfer benefits to take advantage of pension flexibility rules, as CETVs will not be paid.
CETVs can be reduced if there is risk to remaining members in funded public-sector schemes.
This covers the syllabus learning point:
4.7. Describe the structure, main attributes and benefits of public-sector schemes
And continues to cover the following syllabus point:
4.3. Describe the roles and duties of trustees and administrators of pension schemes
4: DB scheme funding
The principle for a statutory funding objective (SFO) is identical for all DB schemes. A DB scheme must have sufficient assets to cover its technical provisions.
The detail of how the SFO is achieved, is contained in two further documents: the statement of funding and the statement of investment principles.
TPR have a Code of Practice that covers this area. This was introduced in line with a government objective ‘to minimise any adverse impact on the sustainable growth of an employer’.
DB scheme valuations must be carried out at regular intervals, to ensure the SFO is being met.
There are several valuation types: ongoing, IAS 19, section 179, and insolvency (section 143).
If the scheme is underfunded, a recovery plan must be put into place by scheme trustees.
Any recovery plan must consider a number of factors, such as: employer financial position, scheme membership profile, any impending changes, and key assumptions.
There are several options available to trustees in terms of improving scheme funding: increasing employer / member contributions, changing future accrual rate, changing investment strategy, transferring in other company assets, changing scheme definitions, and extending scheme NPA.
This covers the learning outcome:
4.2. Describe funding methods and explore issues surrounding funding
This continues to cover the syllabus learning point:
4.3. Explain the role of trustees and other parties, including scheme reporting
5: Closing a scheme
Many private DB schemes have been replaced with DC versions over recent years.
This is due to several factors, including greater administration requirements and costs, deficits under IAS 19 rules showing on balance sheets, and poorer equity returns affecting funding levels.
An employer can take one of two approaches: scheme wind-up or scheme closure.
Scheme rules must contain a termination clause and scheme wind-up must follow a strict order.
A scheme surplus could enhance member benefits, or be returned to the employer, less 35% tax.
A scheme can be made paid-up, which means no new members and no continued benefit accrual, or it can be closed, so no new members, but existing ones can continue to accrue benefits.
This continues to cover the syllabus learning points:
4.2. Describe funding methods and explore issues surrounding funding
4.3. Explain the role of trustees and other parties, including scheme reporting
6: Early leavers
There are several options open to early leavers: short-service refund, short-service pension, immediate crystallisation, and transfer of a CETV.
The options available depend on the member’s length of service.
A short-service refund may be available if the member has less than two years’ scheme service. This refund will be taxed at 20% on the first £20,000 and 50% on any excess.
Short-service pensions will receive at least minimum statutory revaluation.
To crystallise early, the member must be 55, and there are likely to be scheme penalties.
The appropriate pension transfer analysis (APTA) and transfer value comparator (TVC) have been introduced by the FCA from 1st October 2018 and must now be used for DB scheme transfers.
A critical yield is calculated. This is the annual net growth required to match DB benefits.
Independent financial advice must be sought, and confirmed, if the CETV is more than £30,000.
Implications of larger transfer volumes must be considered by scheme trustees.
This covers the syllabus learning point:
4.4. Explain the factors to consider and the benefits on leaving, early and normal retirement including the main transfer issues and considerations in broad terms
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Janet has the following pension schemes:
W: DC OPS with protected tax-free cash
X: Section 32 buy-out bond
Y: DB occupational scheme
Z: Retirement annuity contract with a guaranteed annuity rate
Which of these pensions would be classed as safeguarded?
W, X and Y
W, X and Z
Y and Z
W and Y
Y and Z
The RAC has a GAR and a DB scheme is guaranteed, making these safeguarded.
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John is a member of a DB scheme and is concerned about future annuity rates. He has a cautious attitude to risk. Which of the following is the best way for John to increase his pension contributions
Added years AVCs.
Defined contribution AVCs.
Set up a new personal pension.
Set up a new stakeholder pension.
Added years AVCs
Added years will provide John with additional guaranteed benefits through his existing DB scheme. All the other options are DC-based and will involve investment risk, and possible annuity purchase.
In relation to the DB scheme Annuity rates would only be bad if he was transferring it as the CETV can be lowered or increased depending on the rates
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An employee, who is considering a pension transfer, has requested independent advice from a financial adviser. This is most likely to be because?
His DB scheme is contracted out.
He is within 10 years of scheme NRD.
He is aged 55.
His CETV is £35,000.
His CETV is £35,000.
If a safeguarded rights CETV is more than £30,000, scheme trustees require written confirmation that the member has received independent financial advice, from an individual authorised to carry out regulated activities with the relevant qualifications.
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Bob joined his employer 1/60th DB scheme aged 22. His scheme NPA is 62, but he leaves, due to serious ill-health, aged 51. How would any lump sum be calculated?
40/60th of his final salary.
40/60th of his average earnings.
29/60th of his average earnings.
29/60th of his final salary.
40/60th of his final salary
Even though DB schemes have the choice to either take service to scheme NPA or actual date of leaving, in cases of ill-health most will provide the most generous option. They will use the member’s final salary at the point they left the scheme, rather than average earnings.
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AA corporate bonds returns have increased. This means that the funding rate of a DB scheme is likely to…
Go up.
Go down.
Stay the same.
Be averaged 50/50.
NOTE: In the context of corporate bonds, "AA" refers to a credit rating assigned by rating agencies such as Standard & Poor's (S&P) or Moody's. It indicates a high level of credit quality and suggests that the issuer of the bond has a very strong capacity to meet its financial commitments.
Go down.
Under IAS 19, scheme liabilities must be discounted back into today’s terms using returns from AA corporate bonds. The higher the rate used, the lower the final liabilities. Therefore, an increase in AA corporate bond rates would lead to a fall in funding rates.
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James has died pre-retirement, aged 52, and a dependant scheme pension is now in payment to his widow Alice. This pension will be…
tax-free income.
tax-free income only if a commutation of the member’s pension.
assessed for tax on Alice as a spouse.
a combination of return of contributions and income taxed on the spouse.
assessed for tax on Alice as a spouse.
A dependant scheme pension is always subject to income tax at the recipient’s marginal rate. It will therefore be assessed on Alice.
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Jacob is considering transferring his DB scheme CETV either into a QROPS, or another registered pension scheme. A transfer into a QROPS would be…
potentially subject to an overseas transfer charge.
assessed against the annual allowance.
taxed as an unauthorised payment.
assessed as taxable earnings.
potentially subject to an overseas transfer charge.
A transfer from a UK DB scheme into a QROPS is tested against the overseas transfer allowance (OTA). If the value of the transfer exceeds the OTA, the excess will be subject to a 25% overseas transfer charge.
