This blog was kindly contributed by Professor David Voas, Head of the UCL Social Research Institute.
Members of the Universities Superannuation Scheme (USS) are losing a key benefit, and almost no one knows it.
Currently, you have the option to increase your pension income on favourable terms by giving up some of the lump sum paid on retirement. A recent change in USS rules wrecks that option. The change has not been publicised by the USS, and it seems to have passed by the University and College Union (UCU).
Retiring USS members are entitled to an annual pension that varies with their salary history and length of service and a lump sum of three times that amount. If your annual pension is £20,000, for example, you can receive £60,000 as a one-off cash payment. If you wish, you can forgo some or all of that lump sum to make your annual pension larger, or conversely you can choose to have a smaller pension but a larger lump sum. The USS maintains a table of age-specific commutation factors to calculate the conversion in one direction or another.
At the moment, the commutation factor for someone who retires at age 66 is 19.948. That means that if you choose to give up £10,000 from your lump sum, you will receive an additional 10,000/19.948 = £501 per annum. For anyone in good health, that’s an attractive option, in part because the pension is index-linked and half is payable to a surviving spouse. It’s particularly tempting to anyone with funds in the USS Investment Builder or other defined contribution schemes, for reasons I shall explain below.
In October 2020, the commutation factor at age 66 skyrockets to 28.519. That means giving up £10,000 from the lump sum will buy only £351 a year additional pension, which is unappealing: it’s at best the kind of annuity that one might get on the commercial market.
To add insult to injury, there will be two different sets of commutation factors from October, one for converting pension to lump sum payments and the other for converting lump sums to pension. The old values have been retained for the former: at age 66, you have to give up £501 in annual pension to secure an additional £10,000 in cash up front. By contrast, giving up £10,000 from the lump sum secures additional annual income of only £351. A buy/sell spread is common in financial transactions, but 500 vs 350 is ridiculous.
The USS argues that it is reasonable to apply different commutation factors in these two cases, though it has never done so in the past. In correspondence with me, they stated that the ‘pension is payable for an unknown period of time, which introduces an additional risk’. But someone bears a risk in all insurance and investment arrangements: if you trade cash for an annual income and then die a few years later, beneficiaries of your estate will lose out. The USS is playing heads-I-win, tails-you-lose, with a 30 per cent premium to cover its own risk.
You may wonder whether this issue is really significant. The lump sum is generally free of tax, which reduces the incentive to trade it for lifelong income. In future, however, many USS members will retire with substantial cash savings. In 2016, the USS scheme was split into two sections, the defined benefit ‘Income Builder’ and the defined contribution ‘Investment Builder’. The latter now includes close to 40 per cent of USS members. For everyone in this category, some or all of the funds they build up will fall within the tax-free allowance on retirement. In these circumstances, the option to use the normal lump sum payment to buy a larger pension is attractive.
That possibility is gone, though, for anyone retiring after next month. In theory the option is still open, but the new commutation factor makes it bad value. Only people who feel totally confident of reaching an advanced age are likely to consider it.
This change – apparently decided some months ago – has been hidden from view. The benefit conversion modeller on the USS website is still using the old commutation factors for retirement dates well into the future. The ‘Tax-free cash options at retirement’ factsheet dated March 2020, available online, is grossly misleading. It glibly states that ‘you do not have to opt for this standard package of benefits. All members can take less cash, or in fact no cash at all, and you then receive a higher pension in lieu of the cash’. The single illustration uses a commutation factor of 17 (!), which shows £10,000 turning into an additional £588 in annual income.
As for the UCU, it seems to have been caught napping. These actuarial changes are technical, but experts need to stay on top of developments. No one emerges from this story with much credit.
Can the decision be overturned? I doubt it. The end of benefit conversion is just another episode in the protracted demise of the defined benefit pension.