What is a CEV and how is it calculated?

As CEVs reached record highs earlier this year, our latest blog covers CEV and what it means to pensions and divorces.

By Jonathan Galbraith - February 2021

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Firstly, let us deal with the terminology. CEV stands for Cash Equivalent Value, i.e. the value of each pension arrangement that is sought in a divorce case. However, a scheme member who wishes to transfer his benefits from one arrangement to another will request a transfer value or—to use its full name—a Cash Equivalent Transfer Value (CETV). The different terminology, for essentially what is the same thing, (i.e. a valuation of accrued benefits), arises because not all scheme members have a right to take a transfer of benefits (such as those still accruing benefits in a scheme or those in receipt of a pension); but all members are entitled to a CEV for divorce purposes.

If you read the financial press you will no doubt be aware that transfer values (or CEVs) reached record highs earlier this year. What might not be obvious is that these record highs do not apply to all types of pension arrangements. These record-high transfer values are in respect of benefits that have been accrued in private sector defined benefit schemes, that is those “gold-plated” pension arrangements of yesteryear that promise scheme members a certain level of income in retirement.

The trustees of these schemes are responsible for determining CEVs. The starting point must be that the initial cash equivalent value should be broadly equal to the expected cost of providing accrued benefits within the scheme. Trustees are required to decide on the required financial and demographic assumptions on a “best estimate” basis. This means that the required assumptions should be devoid of prudence and have an equal chance of either over- or underestimating the actual cost of providing the benefits. Legislation allows trustees to pay more than the best estimate amount and there are often reasons why trustees may decide to do so.

The key factors that trustees are required to make assumptions for include:

  • Investment returns or discount rates: These are used to determine how much money is needed today to meet a future promised stream of pension payments. The assumptions here will have regard to the investments held by the scheme and the expected returns on those investments. A future blog will explore the impact of a reduction in these discount rates.
  • Inflation expectations: In general pensions receive inflation-linked or salary-linked increases in the period to retirement and quite often inflation linked annual increases are awarded to pensions in payment. Therefore assumptions are required over the future levels of these inflationary increases as these determine the level of future pension payments.
  • Life expectancy: A defined benefit pension pays out an annual income until a member’s death and then (as discussed in an earlier blog) a different income stream may then be payable to the member’s spouse, civil partner, or other financial dependant. CEVs will therefore be based on mortality assumptions to determine how long a member’s pension and any contingent pensions payable on death is expected to be paid for. Such assumptions typically consider the characteristics of the scheme membership (e.g. location and the nature of the member’s job role).

Trustees must monitor and review the appropriateness of the rationale for determining the assumptions that underlie the calculation of a CEV and this is usually done every three years, with advice from the Scheme Actuary, at the same time as the scheme funding valuation. However, whilst the rationale for the setting of financial assumptions may not be reviewed for three years, the actual assumptions are usually updated monthly to reflect market movements (e.g. in bond yields or inflation expectations).

Members of unfunded public sector pension schemes (such as the NHS or Teachers’ pension schemes) cannot transfer their benefits out of the scheme. The cost of the benefits paid by these schemes are met on a “pay as you go basis” out of general taxation and therefore there is no funding reserve for benefits that have been accrued. This obviously creates a problem if benefits are to be discharged in one payment (i.e. a transfer value), rather than being discharged over the retirement period. However whilst money in the form of a transfer value would never leave such a scheme, members can request CEV quotes for divorce purposes. These CEVs are determined using assumptions set by the Government Actuary’s Department and these assumptions are usually fixed for a few years before being reviewed.

A set of assumptions is not required to determine the CEV in respect of a defined contribution or money purchase pension arrangement. In general the CEV is the value of the holder’s pension pot or fund at the date of calculation, which would be valued in much the same way as a shareholding would be valued as the number of shares held multiplied by the share price. 

Some defined contribution arrangements have implicit guarantees over the value of the fund at retirement and/or the income that may derive from the arrangement at retirement (guaranteed annuity rates). The terms offered by such guarantees may mean that the CEV of the arrangement does not actually reflect its true value. Normally information on the guarantees may only come to light by asking the right questions to the pension provider. The existence of such guarantees is one example of a situation where an expert’s report may be essential. 

Jonathan Galbraith
Head of Product & Risk and Senior Report Writer

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