Top Tips for Trustees: Crystallising discretions on buy-in

Sarah Henderson’s blog last month, “Why the rules are just the beginning…”, looked at steps to building a benefits specification for a bulk annuity policy. One of the steps was crystallising trustee discretions. Let’s look at that in a bit more detail.

Why should you crystallise discretions?

Scheme rules will give trustees various discretions in relation to the benefits being secured. For example, does a benefit arise to be paid? how should a benefit be calculated? who should receive a benefit?

Before trustees enter into a buy-in policy, they will need to decide the basis on which they wish to insure certain discretions under the policy so that the insurer can price the policy and calculate the amounts it is obliged to pay out under the policy. This is often referred to as the process of “crystallising” discretions.

How do you crystallise discretions?

So, how do trustees crystallise discretions?

1. Type of discretion – As a first step, trustees need to identify all relevant discretions and determine whether they should be crystallised under the buy-in policy. This will depend on the type of the discretion. Discretions that determine whether a benefit is paid (such as whether to pay a dependant’s pension if a member dies and does not leave a spouse or civil partner) or how much is payable (such as whether to apply a young spouse’s reduction and at what level) will need crystallising for the purposes of the buy-in. Discretions around how a benefit is distributed (such as how to pay lump sum death benefits) may not need to be crystallised until the point of buy-out at which point the trustees will effectively hand over the discretion for the insurer to operate using its own processes.

2. Established practices – It is likely that there will be established administrative and actuarial practices in place in relation to the discretions. Typically, trustees will obtain input from advisers so that they can crystallise the discretions in line with these practices.

3. Exercising discretionary powers – It may be the case that there are no established practices. If so, trustees should exercise their discretion in line with their usual trustee duties (including, taking into account relevant factors and discounting irrelevant factors).

4. Pricing implications – When crystallising discretions, trustees should factor in the impact on the insurer’s liabilities – will the crystallisation increase in the insurer’s liabilities? In particular, they should consider how the buy-in premium is being met and whether they wish to obtain company input – this is likely to be the case if the company is footing the bill for any increased cost.

5. Insurer capabilities – It may not always be the case that insurers will be willing to insure discretionary practices in the way trustees would ideally wish. For example, insurers may have a standardised and process-driven way of determining eligibility for certain contingent benefits. Trustees should therefore engage with the insurer early on in the process to ensure that they are aware of what the insurer can insure.

6. Good governance – Trustees should ensure that decisions as to how to exercise discretions are made by authorised individuals and are recorded appropriately together with the reasons for the decisions.

Once trustees have crystallised discretions, are they bound to exercise them in that way?

During buy-in

Whilst the policy remains a buy-in, the simple answer is “not necessarily”.

The buy-in policy is essentially just a form of investment providing an income stream for the scheme. The trustees will retain their role to exercise any discretions under the scheme rules in the normal way. However, if trustees exercise a discretion in a different way to what was insured as part of the buy-in policy there will be a “mismatch” between the benefits being paid to members and the money being received from the insurer. This could give rise to a shortfall which would need to be funded by the scheme.

When moving to buy-out

Once the policy has been converted to a buy-out, the trustees will not be able to change how any of the discretions are exercised. Some of the discretions will be set in stone under the buy-out policy, others will simply be passed to the insurer to exercise using its own processes.

Therefore, as part of moving to buy-out, trustees will need to check whether there are any mismatches which need to be addressed. They should also check they are comfortable with how, after the buy-out, the insurer will manage discretions which are passed over to them. The Trustee should also not assume that their insurer will update the crystallised discretions to reflect a change in practice.

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