On December 1, 2020, the rules governing the calculation of pension commuted values will change. Gavin Benjamin, FCIA, joins us to discuss the upcoming changes, the reasons behind the revised rules, and how they could affect pension plan members.
A French version of this episode is also available.
Chris: Welcome to a special edition of Seeing Beyond Risk from the Canadian Institute of Actuaries. I’m Chris Fievoli, Staff Actuary, Communications and Public Affairs at the CIA. Today’s episode is to discuss the upcoming changes to the actuarial standard governing the calculation of pension commuted values.
With me today is Gavin Benjamin, FCIA, an actuary and the Chair of the designated group responsible for revising the standard. Gavin, thanks very much for joining us today.
Gavin: You’re very welcome.
Chris: First question, can you tell us what is a commuted value and under what circumstances can it be paid?
Gavin: A commuted value is a lump sum that represents the estimated present value of the defined benefit or target monthly pension that a former pension plan member is entitled to receive from a pension plan.
There are a number of circumstances under which a commuted value can be paid, so I won’t try to address all of them. But I can speak to a few common examples. If a member of a pension plan terminates employment and is too young to start a pension immediately, pension legislation in Canada requires that the former member be provided with the option of either receiving a monthly pension from the pension plan when they are old enough to retire or instead, having the commuted value of the pension entitlement transferred out of the plan, usually to a personal locked-in retirement account.
In terms of a second circumstance under which a commuted value can be paid, some pension plans also provide the option of electing a commuted value to plan members who are old enough to start their pension immediately when they terminate employment.
Also, in the case of a plan member who terminates employment and has accrued only a very small pension, pension legislation provides the administrator of the pension plan with the option of forcing the former plan member to transfer the commuted value or their accrued pension from the plan.
And the last circumstance I will mention is in the case of the wind-up of a pension plan. In the case of a wind-up, plan members who are not in receipt of a monthly pension at the time of the wind-up are provided with the option or in some cases, this is actually their only option, to receive the pension entitlement in the form of a transfer of the commuted value of their accrued pension from the pension plan.
Chris: What are some of the main changes to the way the commuted value is calculated that we can expect?
Gavin: As mentioned, the commuted value is a lump sum that represents the estimated present value of the pension that a former pension plan member would have been entitled to receive from a pension plan, had they not received the commuted value instead. In order to calculate the commuted value, you have to project the expected monthly pension that the former plan member would have received from the pension plan and then discount the projected monthly pensions with interest back to the date you’re doing the calculation.
To do these calculations, you need to make a number of actuarial assumptions such as the age at which the member would have started their pension, the form of pension they would have elected, the age of their spouse, and how long the retiree and spouse will live, since this affects how long a pension would have been paid from the pension plan.
Also, an assumption must be made about the interest rate used to discount the projected monthly pensions back to the calculation date. The changes to the way a commuted value will be calculated relate to changes to some of the assumptions used in the calculation.
If we now focus to the significant changes, let’s start with the calculation of commuted values for former members of traditional single-employer defined benefit pension plans. For these types of plans, the two key changes are to the interest rate assumption and the assumption regarding the age at which the member would have started their pension, often referred to as the pension commencement age.
With respect to the interest rate assumption, currently the interest rate is updated monthly based on the prevailing yields on Government of Canada bonds. And typically the interest rate used for the calculation of a commuted value will depend on the month in which the former pension plan member terminated employment.
While the interest rate will still vary monthly, a change is being made to make the interest rate more market based, which means that instead of reflecting only changes in Government of Canada bond yields, the interest rate will also reflect the yield on provincial and corporate bonds.
With respect to the pension commencement age assumption, currently, you assume the former member would have started their pension at the age that maximizes the commuted value. This is often referred to as the optimal retirement age.
What’s being changed is that after the changes come into effect, you’ll assume that there’s a 50% probability that the former member would have started their pension at the optimal retirement age and a 50% probability that the former member would have started their pension at the earliest age they are entitled to an unreduced lifetime pension. And these two ages are not necessarily the same.
If we now turn our attention to pension plans that are referred to as target pension arrangements, these are plans that permit the reduction of the crude pensions of active members and retirees while the plan is ongoing in order to keep the funded position of the plan in balance.
Examples of target pension arrangements are certain target pension plans and certain multi-employer pension plans. The calculation of commuted values for target pension arrangements will be fundamentally changed as the assumptions used to calculate the commuted value will look to the assumptions the plan sponsor uses for purposes of funding the pension plan.
Note that I’ve been focusing on what I believe are the key changes to the commuted value rules, but there are other changes as well that are generally less important.
Chris: Can you tell us why these changes are being made?
Gavin: Well, the methods and assumptions used to calculate commuted values are contained in the Canadian Actuarial Standards of Practice. And periodically, the Canadian Institute of Actuaries undertakes a review of the commuted value standards of practice. And so these changes that we’re talking about resulted from a periodic review that was completed earlier this year.
Chris: Can you tell us, generally speaking, what will be the effect of these changes on the amount of the commuted value?
Gavin: Now, it’s very important to understand that the effect of any will depend on individual circumstances because the effect depends on a number of factors.
In some cases, there could be no effect. In other cases, the effect could be very material and there’ll be lots of situations between these two extremes.
With respect to traditional defined benefit plans, the effect of the interest rate change will depend on the level of provincial and corporate bond yields compared to the yields on Government of Canada bonds once the change comes into effect.
Based on bond yields in recent years, the change would have increased the interest rate used to calculate commuted values, which results in smaller commuted values. But there’s no guarantee that this will be the case going forward. And in fact, there have been periods in the past where the methodology that is being adopted would have increased commuted values.
The change to the pension commencement age assumption will usually either result in a reduction to the commuted value or no change to the commuted value at all, depending on factors like a former members age, service, and the early retirement provisions of the pension plan that the former member participated in.
If we move to target pension arrangements, the change in methodology could result in commuted values that are significantly smaller than commuted values calculated under the current rules.
However, it’s important to consider for target pension arrangements that some provinces or in some provinces, there’s pension legislation that prescribes how commuted values from target pension arrangements are to be calculated, and this legislation overrides actual standards of practice.
So for many members of target pension arrangements, there will be no immediate effect due to the changes we are talking about. So as mentioned before, the effect, if any, of the commuted value changes for a particular individual is highly dependent on the individual’s individual circumstances.
Chris: Now, does this change anything for current retirees that are in receipt of a pension payment?
Gavin: Well, since current retirees are receiving their pension entitlement as a monthly pension from their pension plan, these changes will have no effect on this group and also another group of plan members that is unaffected by the commuted value changes are members of defined contribution pension plans.
Chris: Does this change affect all pension plan members across Canada?
Gavin: Yes, these changes potentially affect pension plan members across Canada.
Chris: And when does this change expected to be effective?
Gavin: These changes are expected to be effective December 1st of this year. However, administrators of target pension arrangements can choose to adopt the changes earlier than December 1st.
Chris: And if somebody has questions about their particular situation, who can they talk to?
Gavin: Well, if you’re a pension plan member, because the effect of the changes, if any, will be specific to your situation, I suggest that you speak to the administrator of your pension plan and hopefully, they will be able to provide you with answers to your questions.
If you have questions because you’re deciding whether or not you will elect the commuted value when you terminate employment, keep in mind that there are a number of things to consider when deciding whether electing a commuted value is right for you, so you should also consider speaking with a trusted financial advisor. If you are a pension plan administrator and you have questions about the commuted value changes, I recommend that you reach out to your favorite pension actuary.
Chris: Well, that’s very informative. Thanks very much for speaking with us today.
Gavin: You’re very welcome.
Chris: I’m Chris Fievoli. Thank you for listening to this special edition of Seeing Beyond Risk.