PFA rules on pension dispute: defined benefit vs lump sum conversion

A recent ruling by the Office of the Pension Funds Adjudicator shines a spotlight on one of the most pressing dilemmas in retirement law: the tension between the legal interpretation of fund rules and the financial sustainability of pension schemes.

At its heart, the case asked whether a member’s defined benefit pension - calculated by formula and guaranteed in the rules - could be reduced to whatever annuity an actuarially-determined reserve value might secure in the market.

If the complainant’s interpretation were upheld without qualification, pension funds across South Africa could face serious insolvency risks, compelled to guarantee pensions without regard to actuarial realities or market conditions. Conversely, members may feel aggrieved and disadvantaged when actuarial assumptions reduce their expected benefits, particularly when responsibility for paying pensions is shifted from the fund to external insurers.

The ruling by Deputy Adjudicator Naheem Essop, therefore, sets an important precedent. It affirms that while actuarial reserve values remain the legitimate basis for lump sum conversions - even in defined benefit schemes - the rules themselves must be interpreted strictly. Where the rules define a pension by formula, the capitalised value must be recalculated to secure that pension, ensuring members are not left worse off when benefits are transferred to insurers.

The complaint

The complainant was employed by ZF Services South Africa (Pty) Ltd from 1 April 1995 until his retirement on 31 October 2023. As a member of the ZF of South Africa Pension and Group Life Assurance Fund, he was entitled to retirement benefits calculated in terms of the fund’s rules.

The rules stipulate that a member’s pension is calculated as 2.5% of final salary for the first 20 years of pensionable service, plus 1.5% of final salary for each additional year of service thereafter. Final salary is defined as the average salary over the preceding 24 months prior to retirement.

Applying this formula, the complainant’s accrued annual pension was calculated at R1 347 595.47 per annum (R112 299.62 per month).

However, instead of paying this monthly pension directly, the fund resolved to provide members with a capitalised lump sum, requiring them to purchase an annuity from a registered insurer.

The complainant argued that the lump sum provided - R14 468 962.88 - was insufficient to secure the defined benefit pension promised under the fund’s rules.
When he approached Sanlam, the insurer used by the fund, the annuity quote based on the lump sum yielded a monthly pension of R91 200, significantly lower than the R112 300 stipulated by the fund’s formula. Sanlam further advised that to secure the promised monthly pension of R112 300, a lump sum of R17 million would be required.

The complainant contended that:

• The fund’s rules guarantee a defined benefit pension, not a lump sum subject to actuarial assumptions.
• By applying risk factors twice - once in calculating the lump sum and again when the insurer priced the annuity - the member was unfairly penalised.
• The fund’s decision to absolve itself of liability by transferring responsibility to an insurer contradicted the guarantee inherent in a defined benefit scheme.
• The discrepancy amounted to an 18.9% variance, translating into a R2.53 million shortfall at commencement, with compounding effects over time.

He, therefore, sought relief, arguing that the lump sum should have been R17 million, ensuring that the defined benefit pension was achievable.

The fund’s response

In its response the fund acknowledged that the complainant’s accrued pension was correctly calculated at R1 347 595.47 per annum. However, it maintained that the capitalisation factor of 10.7368740878093, yielding a lump sum of R14 468 962.88, was reasonable and aligned with actuarial practice.

The fund emphasised that:

• The actuarial reserve value is the amount held to meet each member’s retirement benefit under the rules.
• Assumptions regarding mortality, investment returns, and pension increases were necessary to ensure financial soundness.
• The complainant’s benefit was enhanced by surplus distribution, raising his total benefit to R18 346 411 as at September 2024.

The fund conceded that its rules could be more explicit in capturing the intention that pensions be secured via actuarial reserve values, but insisted that the calculation was correct and reasonable.

Independent Actuary’s Report

An independent actuary appointed by the Adjudicator confirmed that:

• The annual pension of R1 347 595.47 was correctly calculated in terms of the Fund’s rules.
• The capitalisation factor of 10.737 was reasonable, with only minor variances possible depending on methodology.
• The discrepancy between Sanlam’s quotes and the fund’s lump sum arose from differences in product features, commissions, insurer loadings, and market conditions.

The actuary noted that while the complainant’s interpretation of the rules - that the insurer should pay the defined benefit pension directly - was arguable, it would render the rules financially unsound. He concluded that the fund’s approach was consistent with industry practice:

• Calculate pension in terms of the rules.
• Capitalise the pension using actuarial assumptions.
• Provide the lump sum to the member to purchase an annuity.

Deputy Adjudicator’s Determination

After reviewing the submissions, the Deputy Pension Funds Adjudicator concluded that the dispute turned not on actuarial method but on the proper interpretation of the fund’s rules. While the fund’s actuarial approach was considered reasonable in isolation, the rules themselves did not expressly authorise the substitution of a defined pension benefit with whatever annuity an actuarially determined reserve could afford.

The Deputy Adjudicator emphasised that in a defined benefit fund, the member’s entitlement is fixed by rule, and the risk of funding insufficiency lies with the employer or the fund - not the member. Rule 4.2.5 specifically contemplates that if paying benefits places strain on the fund’s financial soundness, the employer may be called upon to contribute further. There was no evidence that honouring the complainant’s defined pension would jeopardise solvency.

Accordingly, the Deputy Adjudicator held that the fund was not entitled to compute the capital sum on the basis it had adopted. The complainant’s benefit is defined in Rule 5.2, and the Fund must make available the capital amount necessary to secure that pension, subject to the lawful terms of the annuity contemplated in Rule 5.3.

The Order

The Deputy Adjudicator issued the following binding order:

• The complaint is upheld.
• The fund’s determination of the capitalised value of R14 468 962.88 is set aside.
• The fund is directed, within 30 days, to recalculate the capitalised value required to secure the pension defined in Rule 5.2 - namely R1 347 595.47 per annum at commencement - subject to the rules governing the nature and incidents of that pension.
• The fund must, within the same period, make available or procure the capitalised value necessary to secure such pension from a registered insurer in accordance with the rules.
• The fund must provide the complainant, within 30 days, with a written calculation and explanation demonstrating compliance with this order.