Incentives code applies to certain trivial commutation exercises

Introduction

In December 2014, the Incentive Exercise Monitoring Board Technical Group (the “Group”) published a note confirming that the Code of Practice on Incentive Exercises (the “Code”) applies to one-off trivial commutation / small pot lump sum exercises.  The Group thought it would be helpful to answer this question now, in the light of the potential significant increase in such exercises over the coming months.

In this Alert

• Key points
• The Code
• Trivial commutation / small pot lump sums
• What are incentive exercises?
• Types of incentive exercise
• Who is responsible for compliance?
• On the horizon
• Action

Key points

• The Code applies to one-off trivial commutation / small pot lump sum exercises, as opposed to “business as usual” activity.
• The Group would not expect the Code to apply where members are not being given a choice.
• The Code is voluntary so compliance, while advisable, is not currently obligatory.
• Trustees and employers who have commenced or are considering a trivial commutation / small pot lump sum exercise should speak to their usual Sackers contact as soon as possible about the potential impact of the Code.

The Code

The Code was introduced in response to industry and government concerns that incentive exercises could be conducted in a way that disadvantaged pensions scheme members.  It was written by an industry working group and published in June 2012.  (See our Alert for details.)

The objectives of the Code are to ensure that all incentive exercises are:

• done fairly and transparently
• communicated in a balanced way and in terms that members can understand
• available with appropriate regulated and qualified independent financial advice that is paid for by the employer
• able to achieve high levels of member engagement
• provided with regulated access to the independent complaints and compensation process.

Trivial commutation / small pot lump sums

In the 2014 Budget, George Osborne announced far-reaching changes to pensions.  These included increases to the limits on trivial commutation and the payment of small pot lump sums (see our Alert for details).  With effect from 27 March 2014:

• the amount which can be taken as a lump sum on “trivial commutation”, rose from £18,000 to £30,000
• it became possible to pay a small pot lump sum of up to £10,000 (previously the limit was £2,000).

Further changes to trivial commutation will come into force on 6 April 2015. From that date:

• it will only be possible to pay a trivial commutation lump sum from a DB arrangement.  This is because individuals with DC savings will be able to take an uncrystallised funds pension lump sum (see our Alert for details).
• trivial commutation and small pot lump sums will be payable from normal minimum pension age (currently age 55 or, if the member has one, their protected pension age under the scheme) or earlier if the ill-health condition under the tax rules is met.   Currently such lump sums are payable from age 60.
• to qualify as a trivial commutation lump sum, the lump sum will only need to extinguish a member’s DB benefits under a scheme
• the maximum amount payable as a trivial commutation lump sum death benefit will be increased from £18,000 to £30,000. This change will apply to lump sum death benefits which are paid on or after 6 April 2015, regardless of when the member died.

All these changes are expected to lead to an increase in trivial commutation / small pot lump sum exercises. However, before such an exercise is commenced, trustees should ensure that they have power under the scheme rules to make these payments and, if they do, that all the necessary conditions for paying such lump sums under the tax rules are met.

What are incentive exercises?

For the purposes of the Code, an “incentive exercise” is an invitation or inducement provided to a member to change the form of their accrued DB rights in a UK registered pension scheme which meets both of the following tests:

• one objective of providing the invitation or inducement is to reduce risk or cost for the pension scheme or its sponsor(s)
• the invitation or inducement is not ordinarily available to members of the pension scheme.

The Group would generally expect one-off trivial commutation / small pot lump sum exercises to existing pensioners and dependants to meet these two tests.

Types of incentive exercise

Broadly, the Code deals with two types of incentive exercise:

• “Transfer Exercises” – for example, involving a transfer out of a DB scheme on an enhanced basis or in return for some other inducement (as distinct from a normal individual transfer request)
• “Modification Exercises” – for example, a pension increase exchange exercise (involving an enhancement to pension income in return for surrendering all or part of future pension increases).

The Group considers that a one-off trivial commutation / small pot lump sum exercise would constitute a Modification Exercise. The distinction is important as it impacts on the level of information the party making the offer needs to provide to scheme members.

For Modification Exercises, either:

• financial advice (including a final, tailored written recommendation) should be provided or
• the so-called “Value Requirement” should be met, and financial guidance provided to the member.

For an exercise to meet the Value Requirement, the membership who are offered the incentive exercise must not be worse off, in aggregate, after the incentive exercise than they were before. This is also referred to as a “100% Balanced Deal”.

Calculations are made using the framework for actuarial equivalence tests under section 67 of the PA95.

Who is responsible for compliance?

The party initiating the offer is responsible for following the Code and seeking to ensure that other parties involved comply.  However, the Code is voluntary so compliance, while advisable, is not currently obligatory.

A Monitoring Board comprised of representatives of industry bodies plus a few members of the original working Group is monitoring compliance and will use the information gathered to decide whether the Code should be updated or whether legislation is required.

On the horizon

The Group recognises that the 2014 Budget announcements are likely to have a significant impact on incentive exercises and are planning a major review of the Code in 2015 once government policy, legislation and market developments have become clearer.

Action

Trustees and employers who have commenced or are considering a trivial commutation / small pot lump sum exercise should speak to their usual Sackers contact as soon as possible about the potential impact of the Code.