Anybody who has looked into a defined benefit (DB) pension transfer, would have come across this acronym. A Cash Equivalent Transfer Value (CETV). All well and fine to know what the CETV is, but wouldn’t it be nice to know how it is calculated so that you can have a better understanding on it.
In a DB scheme, the member has safeguarded rights in that they will be given a pension income from pension age until they die; indexed by either RPI, CPI or NAE, as stipulated in the scheme rules.
At any one point in time, these benefits have a cash equivalent value which the member can chose to transfer out of the scheme and in doing so foregoes their safeguarded benefits.
In calculating the CETV, as with so many other financial calculations, certain assumptions have to be made. The CETV calculation is a 4 step process, of which there are three assumptions. The assumptions are those pertaining to inflation, gilt yield rates and assumed investment growth rates. Now that we have covered the basics, let’s get into the calculation.
The first step is simply calculating the members benefit at the date of leaving the scheme (or at the date of calculation if they are still a member). In calculating this no assumption is made as all variables are known. The duration of service, their pensionable salary and the schemes accrual rate (the rate in which benefits accrue due to employment).
If an employee is a member of a scheme and it is a 60th scheme, for each year worked (and contributed to the scheme), 1/60th of their final salary is accrued as pension benefits. Let’s assume a member had a pensionable salary at the date he left the scheme of £50,000 and he had been a member for 30 years. The calculation is simple; £50,000X(30/60)=£25,000.
Step 1 completed; onto the next step and the first assumption. The pension benefit as calculated in step 1 is at the date the member left the scheme and this now needs to be factored up to the scheme’s normal retirement age (NRA). In doing so a simply time value of money calculation is used, as well as the assumed rate of inflation. The formula is FV=PV(1+r)^n. Let’s assume our member had another 10 years until he reached the scheme’s retirement age, and the scheme actuaries assume an inflation rate of 2%, then the £25,000 will be increased to £30,474.86 (FV=25,000(1+0,02)^10).
This is the future value of the accrued pension benefits, and forms the basis for the third step; capitalising this future valued benefit. The actuaries will use the gilt rates to capitalise this value, however, such rates would need to be assumed as although known at present, they may very well change in the future. To capitalise the future benefit, simply divide such benefit by the gilt rate (expressed as a decimal). Assume the gilt rates are 3%, then £30,474.86/0,03=£1,015,828.67
This future capitalised value is the value that would need to be available in 10 years time. However, between now and then it is assumed that the transfer capital will be invested and hence we arrive to the last part of the calculation, discounting the future capitalised value to present value. In order to do this, the actuaries (of the ceding scheme), will assume a growth rate (i.e. annualised rate of growth of the capital if invested now until retirement). The longer the period between the date of calculation and the member’s NRA, the higher the discount factor would be. The assumption underlying this is that with a longer timeframe, more of the capital can be invested in equities and hence a higher growth rate can be expected.
If we assume a 4% growth rate, then the future capitalised value will need to be discounted by this over a period of 10 years. Once again, using a simple time value formula we can ascertain this present date amount. PV=FV/(1+r)^n. Let’s plug in the numbers. PV=£1,015,828.67/(1+0,04)^10=£686,257.45
And, just like that you have your CETV of £686,257.45. The best way to now understand this calculation is as follows. If we invest £686,257.45 today for a period of 10 years and achieve an annual growth rate of 4%, then in 10 years time the capital would be £1,015,828.67. At that time (10 years from date of calculation), if the capital was used to purchase an annuity of 3%, then this annuity would pay out an annual amount of £30,474.86. This annual income of £30,474.86 would have the same purchasing power as £25,000 has today, in 10 years time (if inflation is 2% per annum from date of calculation up to the member’s NRA).
This understanding can be checked using the formulas as follows:
£686,257.45(1+0,04)^10 = £1,015,828.67. Then we can take the £1,015,828 and multiply by 0,03 as representative of the 3% annuity rates. This provides us with £30,474.86. If we discount this by the inflation rate (2%) over the 10 year period (30474.86/(1+0,02)^10); we end up with £25,000 which is the exact same amount as the pension benefits owing to the member at date of leaving the scheme.
As one can see a CETV calculation is not a science due to the amount of assumptions. The purpose of this piece was not to judge the suitability of the CETV but rather to enlighten those who have received one to understand a little more how the scheme actuaries arrived at such amount.
If you want to see how this works in action, why not try a FREE calculator I have created. You can access the file by following this link. Please note, I recommend you download the Excel spreadsheet before populating it to ensure the auto-calculations all function correctly.