SAC 305:Pension Mathematics
Topic No.4
Course Lecturer: Johnstone k munywoki
TOPIC 4
Guarantees and Options
Many benefit packages include options and guarantees. Options may enable
employees to tailor the benefits to their own requirements. Guarantees may
help to protect members against certain risks e.g. poor investment returns.
Where options and guarantees are available, the sponsor takes on an additional
financial risk.
The actuary therefore may be required to provide a realistic point estimate
of the cost of an option or guarantee and a range indicative of the potential
variability of the cost.
Guarantees
(a) Minimum Benefits
Common guarantees relate to providing a minimum value of benefits for the
contributions made to a defined benefit scheme or conversely a minimum level
of benefits from a defined contribution scheme. Examples are:
• A defined benefit scheme may guarantee that the value of the benefits
payable is no less than a defined contribution minimum - this could protect
members who leave the scheme at an early age
• A define contribution scheme may have a defined benefit underpin - this
could protect members against low investment returns
(b) Benefits granted in respect of transfer in and
additional contributions
Another type of guarantee may occur in relation to the benefits offered in rela-
tion to a transfer into the scheme or additional contributions.
The additional benefits offered may be provided on a defined benefit or
defined contribution basis. Additional defined contribution benefits pass the in-
vestment risk to the member and can be used within a defined benefit scheme or
a defined contribution scheme. The advantage of granting an additional defined
benefit within a defined benefit scheme is that the supplementary benefits can
be consistent with the main scheme benefits.
A member who transfers from one scheme to another can be disadvantaged
by the relative prudence of the assumptions used to value benefits. An opti-
mistic basis in the original scheme will place a low value on the benefits to be
transferred. A cautious basis in the receiving scheme will place a high cost on
the benefits to be provided and result in a low level of additional benefits in
relation to the funds transferred.
Options
Options that may be granted in relation to retirement benefits include:
• A transfer to another scheme
• Early receipt of benefits
• Late receipt of benefits
• Conversion of the benefits from pension to cash or vice versa
• Transfer of benefits from one beneficiary to another
In all cases the alternative benefits can be determined by setting up an
equation of value. The value of the different benefits is set equal on a given set
of assumptions.
Early Retirement
Description of the option
Some members may want to draw their benefits before normal retirement age.
In some schemes members may have a right to retire early.
Setting the terms for the option
The value of benefits payable could be determined in relation to the benefits
that would be paid in the individual:
• Remained as a member until the benefits become due normally. This is
the most valuable option and may be used to protect members who are
forced to retire early e.g. through redundancy or ill-health
• Remained as a member without occurring any further benefits
• Ceased being a member immediately. This is usually the last valuable
option
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The equation of value would be of the form
lN RA r
Earx = P v N RA−x a
lx N RA
Where x is the age the individual at the point of early retirement
N RA is the normal retirement age
Eis the early retirement pension to be paid
lN RA and lx are from multiple decrement tables
P is the pension that would be payable from NRA if the individual did not
retire early
Commutation
Description of the option
The retirement benefits available from a pension scheme are typically a combi-
nation of regular income and a lump sum.
The lump sum that is provided by surrender of each 1 a year of pension is usu-
ally referred to as the commutation factor. The residual (or post commutation)
pension is the pension payable to the member after allowance for the commu-
tation option.
So,
pension surrendered = Commutation lump sum divided by Commutation
factor
And
residual pension = pre-commutation pension - pension surrendered
Setting terms of the option
The assumptions may again be based on the valuation basis or a more realis-
tic basis. Here the strength of the basis depends only on the post retirement
assumptions.
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Funding for options
In placing a value when monitoring the scheme, it may be appropriate to assume
that the highest cost option is always exercised. This may, however, build too
much caution into the valuation. The assumptions, for example, may indicate
the highest cost for an option that is in reality unlikely to be most valuable for
the individual or chosen the most.
When calculating the level of contributions required to meet the cost of provid-
ing the benefits, it is prudent to allow for the possibility of members exercising
the options with the highest cost. However, the actuary should consider the
prudence of the set of assumptions as a whole to avoid including unnecessarily
large safety margins. For example, a realistic financial basis may be used with
prudent assumption about options, or a prudent financial basis with a realistic
assumptions about the options.
In funding early retirement, heavy allowance is often made for members retiring
at the earliest age which may do so on beneficial terms and without obtaining
consent. however, if consent is rarely withheld, allowance may be made for re-
tirement at an early age.
The actuary should discuss the current and future policy for granting consent
with the scheme managers and the sponsor to make an informed judgment about
a prudent allowance.
Many employees do not retire at the earliest opportunity because they cannot
afford to do so. Even though the terms on which the scheme benefits are payable
may be beneficial in an actuarial sense, members retiring really will often suffer
a large drop in income because of the relatively short period over which their re-
tirement benefits have built up. They may prefer to remain in paid employment
and continue to accrue benefits from the scheme.
