In one of our previous blogs we looked at what a Cash Equivalent Value (CEV) is and how a CEV is calculated. However, any readers who are familiar with our pensions on divorce reports may also have seen references to Open Market Values (OMVs) in our reports.
The OMV of a pension benefit is exactly what is sounds like—it is our best estimate of the cost of buying in the open market the benefits promised by the scheme, based on our current view of medium to long-term market conditions relating to annuity rates, interest rates and inflation.
The CEV of defined benefit pension benefits often undervalues the true cost of buying these benefits on the open market. For public sector pension benefits, CEVs are typically around 50% of the true value. For private sector pension benefits we see a wide range of CEV to OMV ratios—we recently saw a case involving a private sector defined benefit pension where the CEV represented approximately one-third of the OMV, but many ratios are as high as 70–80% coverage and in some cases the CEV exceeds the OMV.
For defined contribution arrangements the OMV typically is equal to the CEV, which is valued as the market value of the underlying assets plus in some cases an element of added bonus. However, as we discussed in our earlier blog, for a defined contribution arrangement which has guaranteed annuity rates or other implicit guarantees the CEV may not reflect the true value of the arrangement. We would then calculate the OMV of the benefit, taking into account these, sometimes extremely valuable, guarantees.
As we saw in the earlier blog, the basis for calculating CEVs in each defined benefit scheme is set by the trustees of that scheme, which leads to the wide range of CEV to OMV ratios which we see. This variation in valuation bases means that CEVs of defined benefit schemes are not directly comparable with each other, as well as not being automatically comparable to defined contribution CEVs. By calculating the OMV of all of the pension benefits in a particular case we can then be confident that all benefits are in the same “currency” and hence are directly comparable. Further, by calculating the market value of the pension benefits it becomes much easier for them to be compared to the—often significant—non-pension assets in a case, for example other non-pension investments and/or equity in the Former Matrimonial Home (subject to suitable adjustments for tax and utility).
A pension sharing order (PSO) will always be applied to the CEV as calculated by the scheme administrators, never to the OMV if that is different. Therefore, if the Letter of Instruction asks us only to calculate the PSO required to create equality of income there will be no need to consider OMVs in the report (although we may do so in the background to decide which pension should be shared, if there is a choice of which to share).
If we are asked to comment on the “true value” of the pension benefits held by the parties we will calculate the OMVs of the benefits. Further, if we are asked to calculate the PSO required to equalise capital values we will typically use our calculated OMVs to do so, unless there are good reasons pertinent to that particular case to not do so, in which case we would explain these reasons in the report (for example, if there were only defined contribution benefits with no underlying guaranteed to be taken into account).
We also use OMVs in our offsetting calculations; as noted above, OMVs are the market values of the pension benefits and as such can be more readily compared with non-pension assets, which is the purpose of offsetting calculations.
As noted above, in some cases we find that the CEV of a pension exceeds its OMV (this could happen where the trustees had agreed a particularly generous CEV basis, which they might do for a number of reasons). In such cases we set the OMV equal to the CEV, using the following analogy as explanation: suppose I owned an oil painting that was valued by experts at £200,000, but then a potential purchaser today offered me £250,000 for it. I would regard the higher figure as the true value of the oil painting, on the grounds that this is the amount of money I can realise immediately in respect of it. This would therefore supersede any “theoretical assessment” of the painting’s value as carried out by an expert.
Finally on the topic of OMVs, as Bank of England base rates fall, we would expect Government bond yields (“gilt yields”) to reduce also. As many defined benefit pension schemes invest in Government bonds, such a change would be expected to lead to an increase in CEVs (the expected future investment returns is lower meaning that more money needs to be held now in order to provide the benefit promise on retirement). However, the extent of the change will be dependent on the CEV calculation basis set by the trustees, meaning that CEVs will not necessarily change proportionally.
Of course, such a change in investment markets would also be expected to lead to lower OMVs, and therefore we may not see much change in the ratios of CEVs to OMVs. One exception to this would be in the case of public sector defined benefit schemes. The CEV bases for these schemes are generally less “dynamic” and use tabulated age-related factors which are reviewed by the Government Actuary’s Department from time to time, hence whilst the OMVs of these benefits may increase, the CEVs will not do so, at least in the shorter term.
In conclusion, there are various ways in which pension benefits can be valued, and much depends upon who is performing the valuation and to what end. We see it as an important part of our role—in the production of expert witness pension reports upon divorce—to place consistent values on the various pension benefits, and we do this through the calculation of such OMVs.
Jonathan Galbraith
Head of Mathieson Consulting Limited
