The Incentive Code and trivial commutation

16 February 2015

The Code of Good Practice on Incentive Exercises (the Code) was issued in June 2012 by an Industry Working Group. It has recently gained a little more bite as the body which monitors incentives and use of the Code has stated that it applies to

The Code - a brief overview

The Code of Practice on Incentive Exercises (the Code) applies to invitations to members of defined benefit schemes to accept something in return for sacrificing some or all of their pension rights under that scheme, if the invitation satisfies two tests.

The tests are:

  • first, that the objective of the exercise is to reduce risk or cost for the pension scheme or sponsor, and
  • second, that the inducement is not ordinarily available to members of the pension scheme (often referred to as not being "business as usual").

The Code deals with two types of incentive exercise, "transfer exercises" and "modification exercises".

Transfer exercises involve the member transferring out of the scheme, typically, an "enhanced transfer value" (ETV) exercise under which the member transfers benefits out of the scheme but receives more than the statutory minimum transfer amount ordinarily available.

Modification exercises involve the member staying in the scheme but reshaping his benefits, for example, a pensions increase exchange (PIE) where the member gives up the right to annual pension increases but receives a higher, non increasing pension instead.

If the tests are satisfied, the Code requires independent financial advice to be provided to members, though for modification exercises, it is possible to provide guidance rather than advice if a "value requirement" is met. Additionally, cash incentives are not permitted, there are safeguards for "vulnerable clients" (e.g. members aged over 80 can only particulate on an "opt in basis") and requirements are set out regarding how the incentive exercise is communicated and conducted.

December's announcement

The Incentive Exercise Monitoring Board stated in its "Q&A" section in December that the Code applies to trivial commutation exercises which are not "business as usual".

Why has this become an issue?

Many trustees and employers are carrying out trivial commutation exercises following the March 2014 increases to the commutation limits.

If the trivial commutation is at the member's option, but initiated by the scheme writing to the member asking him if he would like to take it, it is difficult not to see this as an "invitation" - so we have to apply the Code's two tests, mentioned above.

As the aims of trivial commutation are likely to include an element of cost-saving (even if only in terms of the administrative savings of not having to deal with a multitude of small pensions), the Code's first test is likely to be satisfied.

The key question is really whether trivial commutation is "business as usual".

What is "business as usual"?

If trivial commutation is a permanent option which can be exercised by a member at any time of his choosing (subject to his meeting the necessary conditions) then the Code would not apply.

Whether or not a trivial commutation exercise constitutes "business as usual" will be determined by the combined effect of the scheme rules, any relevant trustee exercises of discretion that are needed to give effect to the commutation, and the way in which it is communicated to members. There will be some communication exercises capable of being outside the Code's remit. However, the position will vary from scheme to scheme, and from exercise to exercise, and careful consideration is needed.

Applying the Code to these commutation exercises

Where the Code does apply, members must be given "advice" or "guidance". The Board said it is reasonable to work on the basis that these sorts of incentives are "modification exercises". This means that guidance rather than advice can be used if the transaction satisfies the necessary value requirement (referred to in the Code as the "Balanced Deal").

Guidance is therefore sufficient where the value of the trivial commutation lump sum is actuarially equal to the value of the rights given up (calculated on a cash equivalent transfer value basis). If the value is less than that, the value requirement will not be satisfied, so financial advice must be given to the member.Trivial commutation factors are often different from Cash Equivalent Transfer Value factors and actuarial input will be needed.

The cost of advice and guidance would need to be met by the person making the offer - likely to be the trustees or employer.

The exercise would need to comply with the Code's other requirements, which include requirements regarding vulnerable members, how the offer is communicated and various procedural matters.

Comment

Whether the Code applies or not is not as significant as it might first appear, because even where it does not apply, trustees and employers are still asked to be mindful of its principles.

In particular, we would expect most of the points under Principle 3 of the Code - fair, clear, unbiased and straightforward communications - to be applied. Given that the Code exists to protect members, trustees in particular will not consider it appropriate to be looking for loopholes in it.

That said, while the Board's interpretation of the Code is sound, the conclusion that trivial commutation exercises are within the scope of it is contrary to what many would have thought to be the case. In trivial commutation, the aim is typically to reshape the benefit into a form that is more rational (i.e. a lump sum) because of its low value - there is typically no real incentive element, as such, unlike with a PIE or an ETV.

The "business as usual" exemption is helpful, and it is likely to mean that some communication exercises on trivial commutation can take place without the Code applying, but the Code is due to be reviewed in 2015 and it is not certain that this exemption will continue to exist.

Finally, although neither the Code nor the Board's word is the law, the Ombudsman will have regard to it in any dispute, so it is important for trustees and employers to consider it carefully.


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