Pension plan members typically become more focused on their pension as retirement approaches, with some wondering whether they can commute this valuable asset.
To their chagrin, many employees discover that the period during which they could have commuted their pension has passed. Thus, both plan members and their advisors will want to understand the rules around commuting a pension.
This article does not discuss whether a pension should be commuted; it focuses on whether it can be, and how the commuted value is calculated.
What are the rules?
Pension standards legislation, which establishes a plan member’s rights with respect to commuting a pension, varies between jurisdictions. The commutation provisions specific to the plan are set by the employer, so the plan member and advisor will also want to understand what’s been incorporated into their pension plan.
For a commuted value (CV) to arise, there must be a termination of employment or a termination of the plan’s defined benefit provision. However, a CV could also arise if the plan member dies, or if their marital or other conjugal relationship breaks down.
Let’s meet Alain, 53, who works in Hamilton, Ont., and whose benefits are subject to Ontario’s Pension Benefits Act (PBAO). Alain decides to retire and asks his HR department about portability options under his plan. He is told the normal retirement date (NRD) for the plan he belongs to is 62. (Under the PBAO, the NRD can’t be more than one year after the member has turned 65). The PBAO also allows the plan to determine whether a member can commute their pension in the 10 years leading up to the NRD. Alain’s employer had decided that a plan member would not be permitted to commute their pension after age 52. Thus, Alain is surprised to discover that he cannot commute his pension.
Next meet Amanda, 54, who works in Alberta and is starting to think about retiring. Her benefits are governed by Alberta’s Employment Pension Plans Act (EPPA). Amanda’s employer set the pension eligibility date (PED) as age 65. The EPPA allows an employer to restrict CV transfers from the plan once the plan member is within 10 years of the PED and her employer adopted this restriction. Amanda was pleased to discover that she would still be able to commute her pension, provided she retires before she turns 55.
Plan members and their advisors will want to have a clear understanding of the deadline for commuting pensions and do the appropriate analysis of whether commuting the pension is the appropriate course of action.
How is the CV calculated?
Commuted values must be calculated in accordance with the Canadian Institute of Actuaries’ standards (the CV Standards).
The CV is the lump-sum amount equal to the actuarial value of a future series of benefit payments.
As a starting point, the actuary will determine the member’s pension entitlement under the plan. Then, a number of assumptions come into play. These include mortality rates, discount rates, retirement date and indexing assumptions. They are determined based on the pension plan document and in accordance with the CV Standards.
For the CV interest rate, the CV Standards stipulate that the rate be calculated every month on a 10-year select and ultimate basis (i.e., an initial rate for 10 years and then an ultimate rate thereafter) based on seven-year, long-term and real return Government of Canada benchmark bond yields (as published by the Bank of Canada in its CANSIM tables).
In Table 1 we show rates for a non-indexed plan and for a plan indexed to the consumer price index (CPI). While the Bank of Canada publishes its CANSIM tables and these rates affect the rates in the table, there is not a direct correlation. For example, a rise of 25 basis points in the Bank of Canada overnight rate does not cause an increase of 25 basis points in the rates in the table.
Table 1: Sample commuted value interest rates
|Non-indexed plan||Plan indexed to CPI|
|Unindexed first 10 years||Unindexed after 10 years||Fully indexed first 10 years||Fully indexed after 10 years|
Source: Hart Actuarial Consulting Ltd.
Let’s look at the rates used for non-indexed plans. For plan terminations in May 2018, a 3.2% rate would have been used for the first 10 years, and 3.5% thereafter. From the table we can see that the rates change monthly.
When we look at the rates used for plans that provide benefits that are indexed to CPI, we see especially low rates. For plan terminations in May 2018, a 1.6% rate would have been used for the first 10 years, and 1.7% thereafter.
A plan member may receive an estimate of their pension and CV prior to termination. But this is only an estimate, and the final amount will be calculated at the time of termination. It is absolutely essential that the plan member who is planning to commute their pension understand the time limits for making an election and the period for which the CV shown on the termination statement will be held constant.
The effect of low interest rates
We have been in a historically low interest rate period. The low rates used in calculating CVs are driving up the values. In a recent article (Advisor’s Edge Report, December 2017), we talked about the calculation of the maximum transfer value (MTV), which limits what can be directly transferred to a (locked-in) retirement arrangement. As stated in that article, the factors used in the MTV calculations have not been updated since they were established in 1990-91. This causes most plan members to have a significant excess that cannot be transferred. Hence, a plan member commuting their pension may face a significant tax bill.
How rate-sensitive is the calculation of the CV?
Let’s look at a member of a rich DB plan. This plan member was 54 on Jan. 31, 2018, at which time they could start their lifetime retirement benefit of $4,800, plus a bridge benefit of $900. The CV (using a 1.3% rate for the first 10 years and a 1.5% rate thereafter) was $1,886,000. Of this amount, $1,300,000, or 69%, was taxable.
Clearly, the low rates had driven up the CV (the lower the assumed rates, the larger the amount required to meet the pension obligation). Let’s look at what a change of 10 basis points in the rate means. If the interest rate decreased by 0.1% to 1.2% for 10 years, and 1.4% thereafter, the $1,886,000 would increase by $35,000 to $1,921,000; similarly a 0.1% increase in the rates would reduce the CV by $35,000.
Are there other times at which a pension can be commuted?
Plan members and their advisors will want to understand the provisions, as the pension standards legislation only sets minimum standards.
For example, in Ontario, some plans permit commutations within the 10-year period prior to the NRD. Others may allow an employee to become a deferred member who has a right to commute their pension at a later time (but prior to when they actually start to draw it).
A CV is also typically provided when a plan is wound up. It might also be calculated where an employer does a plan conversion (that is, a DB pension plan is converted to a DC plan and the employer shuts down the former). Typically, the CV of the DB provisions become the starting balance of the DC provisions.
Pension adjustment reversal (PAR)
Plan members and their advisors reviewing pension termination statements may see a reference to a PAR. If there is a PAR amount, RRSP room increases accordingly. The PAR arises where the portion of the CV relating to the post-1990 period is less than the sum of the pension adjustments that had been reported for that same period. A PAR is extremely unlikely in the current low-rate environment. Hence, plan members should not expect an increase in their RRSP room on account of a PAR.
Plans with solvency concerns
Even though a member may be entitled to a CV, the plan may not be fully funded at the time the member terminates. (This is not an uncommon situation in today’s low-interest environment.) Pension standards legislation may not allow the member to transfer their entire CV out of the plan as a single lump sum. Members of poorly funded plans will want to speak to their HR departments about possible limitations on transfers and ascertain the period over which they can expect to receive the remainder of their funds. The remainder is typically paid over five years.
Many members of DB pension plans are seeing large CVs. Often the pension is their major asset. In fact, the CV may have a greater value than their home. The appropriate analysis must be done at the time of termination.