PENSION
PATHS
Should you transfer a commuted
value from a DB pension plan?
By Ashley Crozier
People who change jobs and are in a
defined benefit (DB) pension plan get
to choose whether to leave their benefits in the pension plan of their former
employer, or transfer the commuted
value to their individual locked-in registered plan. Many place a higher value
on the lump-sum amount and quickly
elect that option. But is this the appropriate choice?
A DB pension plan provides a
monthly pension in retirement. Consider Mary who is age 50 and has a
$1,000 monthly pension starting at age
65 in the DB plan of her former
employer. She may start the pension as
early as age 55 (age 50 for some plans).
For now, assume it will be actuarially
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reduced if she starts it early (i.e. reduced
ial calculation is done to determine the
to an amount that has an equivalent cost
lump-sum value, weighted by the probas the $1,000 starting at age 65), so the
ability of living to each age. The result
value is based on assuming she starts her
can be considered as a payment payable
pension at age 65.
for a term equal to life expectancy. This
The commuted value
equals the lump-sum present
he commuted value must
value that needs to be invested
fully reflect all aspects of
today to provide her pension.
the DB plan, including ancillary
By law, it’s based on current
benefits.
long-term interest rates and
given mortality rates. In most
provinces, unisex mortality rates are to
is not necessarily accurate, but it is
be used, reflecting the actual demointuitive, easier to understand and
graphics of the plan (i.e. if most memshould give similar results.
bers of the plan are male, then mainly
For calculations performed in June
male mortality rates will be used in the
2006, annual interest rates of 5% for
unisex rates, and vice versa). An actuarthe first 10 years and 5.25% thereafter
T
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are to be used, each of which is based
on current yields on long-term government bonds. The rates change each
month as the bond yields change.
In Mary’s case, only 5.25% interest
is used during the retirement years, as
she has more than 10 years before age
65. The table on page 29 shows that her
pension has a commuted value of
$69,600. This is the lump-sum amount
that the plan is willing to pay as a
replacement for her future monthly
pension. In theory, both the plan and
the former employee should be indifferent about whether the commuted
value or deferred pension is taken.
The commuted value must fully
reflect all aspects of the DB plan,
including ancillary benefits. For example, if the monthly pension is indexed
for inflation, then the commuted value
needs to consider this.
Similarly, it must recognize enhanced
benefits on early retirement, such as
i) the ability to start early with no
reductions, ii) reductions that are more
generous than actuarial equivalent or
iii) a bridge benefit payable to age 65.
Lastly, any death benefits are reflected,
including guaranteed periods or pensions payable to a surviving spouse on
the death of the employee.
Suppose that instead Mary was in a
pension plan with generous ancillary benefits. In actuality, her commuted value for
the same $1,000 monthly pension could
be as high as $200,000! So depending on
the plan terms, the value of Mary’s pension ranges from $69,600 to $200,000.
This possible range is precisely why financial advisors have a difficult time understanding how the commuted value is
determined. The plan terms have as much
impact, if not more, than current inter-
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est rates and age of the employee.
Take It or Leave It?
Any employee who quits and who is not
yet eligible to retire (under age 55 for
most pension plans) must be given the
option of transferring the commuted
value of his or her benefits from the
pension plan. If they are eligible to
retire, the law does not require they be
given the commuted value transfer
option, and it is up to the plan to decide
whether to offer it. (This decision is
made for the plan in total and not for
specific employees.)
As Mary is not eligible to retire, she
has the option to transfer her commuted
value. There are several issues to consider
when deciding which route to take. On
average, the two decisions (either transferring the commuted value or leaving her
pension in the plan) are of equivalent
value, but Mary’s circumstances may not
necessarily be average, and may therefore
affect her decision. Electing a transfer
means Mary accepts the responsibility to
invest the commuted value and provide
her own retirement pension going forward. The decision then becomes an issue
of whether she can replace the pension
she would otherwise get from the plan
and the death benefits.
Consider these factors:
The interest rate used to calculate
the commuted value. This represents
the average investment return that needs
to be earned in order to replace the
monthly pension. As her commuted
value was based on 5% and 5.25%
interest, Mary needs to earn at least this
much. Whether she can depends on
future returns and investing strategies.
If she is conservative and will only
invest in GICs, then her returns will
currently be lower and it is unlikely she
will earn enough on average to replace
her pension. The pension plan can be
considered as providing this conservative, guaranteed option, so is perhaps
the better choice for those who would
invest conservatively.
Alternatively, balanced investments
with some exposure to equities should
earn at least this high a return on average over the long term. Note that Mary
needs to consider how she may invest in
retirement, as the funds will last that
long. Will she decide to invest more
conservatively as she gets older? If so,
then this should be reflected when
considering the returns.
The current low-interest rates used
to calculate the commuted value give a
low hurdle for a balanced investment
fund to “outperform” in the long term.
But, one needs to pay attention to interest rates. If the interest rates used to
calculate commuted values increase, the
hurdle investment return also increases,
making it more difficult to achieve for
those considering this option in the
future.
Mary’s expectation of her future
lifetime and whether she wishes to take
any of the financial risk/reward on the
uncertainty. The pension plan pays her
retirement income for her lifetime,
whether she lives to age 100 or only to
age 70. As shown in the table, the life
expectancy for someone age 65 is calculated as age 84. Note that the
expected lifetime gives the age when
roughly 50% of the people have died,
but it also means that 50% are still alive
and will live longer! No one knows
how long Mary will live, but there is a
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25
Continued from page 25
possibility she may live beyond age 84.
To the extent she does, a slightly higher
return on her investments is needed
to compensate. For example, a 6.3%
dollar-weighted, compound average
investment return is required to pay the
pension until age 100.
Many people want to transfer their
commuted value because they say their
families will get nothing from the plans
if they die. This is wrong. If they die
before they retire, the plan must pay the
spouse or beneficiary at least the commuted value of the pension, assuming
no death occurred. Also, at retirement,
the employee has the option to elect a
death benefit if he or she wishes,
including five, 10 or 15 years of guaranteed payment and/or a pension that
continues to the spouse (e.g. 60%,
67%, 75% or 100%). These death
benefits will be available at an equivalent cost, meaning the monthly pension
is reduced, but it does provide some
peace of mind for the employee. If the
employee has a spouse when the pension starts, the law requires a joint pension with 60% continuing to the spouse
for their remaining lifetime, unless the
spouse agrees to waive this benefit.
If Mary has a shortened expected lifetime due to a terminal illness, then there
may be a benefit to taking the commuted
value. But most people ignore the possibility of living too long and instead focus
on the prospect of dying early.
Suppose Mary was in a plan with
generous ancillary benefits and a
$200,000 commuted value for her
$1,000 monthly pension. While the
plan is required to pay the $200,000,
the Income Tax Act gives a maximum on
the amount that may be transferred to her
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individual registered plan. The maximum
Consider the current funded status of
transfer is the annual pension at age 65
the pension plan. If the plan is in a deficit,
times an age-based factor. For Mary, it
as is the case currently for many plans,
is $112,800 [ = $1,000 x 12 x 9.4],
then it is possible not all of the commeaning the remaining $87,200 is paid
muted value will be paid currently. Only
to her and taxable when received. This
the portion that is currently supported
accelerates the timing of paying taxes and
by the plan’s assets may be paid now,
means the realized investment returns on
unless either the commuted value is small
this portion of the commuted value will
or the employer agrees to make payments
also be taxable each year. This
increases the investment return
f the plan is in a deficit,
that must be earned to replace
then it is possible not all of the
her monthly pension.
commuted value will be paid
An ancillary benefit, often
currently.
provided, is the ability to
retire early with an unreduced pension or at least reductions
to the plan to fund the shortfall for the
more favourable than the actuarial
transfer. For example, if the plan’s assets
equivalent. The commuted value is corat the last actuarial valuation equal only
respondingly higher as it needs to rec80% of the windup liabilities, then only
ognize such benefits (if they are pro80% of the commuted value may be paid
vided to former employees who do not
currently. The other 20% may be held
retire from active service). If Mary
back and paid out with interest over a
decides to leave her pension in the plan
period of up to five years.
but does not retire early, then she loses
We have often heard employees elect
this higher value of the early retirement
a transfer because the plan has a deficit
benefits. The commuted value needs to
and they are concerned about the finanreflect it, but if she takes a deferred pencial viability of the employer. This
sion, her future decision determines
should not be an issue as the pension
whether she gets the value. In this case
assets are separate from the employer and
she may be better advised to take the
the law in most jurisdictions requires
commuted value in order to realize the
employers to fund deficits over five years.
higher dollar amount. This works out
Also, Ontario plans are protected by the
to lowering the investment return
Pension Benefits Guarantee Fund for up
she needs to earn to replace her pension,
to $2,000 of monthly pension. So leavor increases the expected retirement
ing their benefits in the pension plan
income for the same investment return.
should not mean greater solvency risk.
Some plans periodically index penAlternatively, some plans still have a
sions on an ad hoc benefit. As it is not
surplus. Should the plan wind up with
contractual, the commuted value does
a surplus in the future, the members
not reflect this benefit. One should conmay get some of it. The eligible group
sider the likelihood of indexing conincludes all who remain members in
tinuing in the future, which they would
the plan, but often excludes former
Continued on page 29
not get if they take the transfer.
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27
CASH ACCUMULATION
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employees who elected to transfer their
commuted value from the plan.
Determine if the employer provides
retiree healthcare benefits. Do former
employees qualify for such, and do they
lose eligibility if they elect to transfer
the commuted value of their benefits
from the pension plan? These factors are
something older employees need to
consider. Many employers are starting
to link the payment of a pension with
eligibility for any retiree healthcare benefits. For example, Mary needs to know
whether she could lose entitlement to
such benefits, and consider the value.
In the case of an employee being terminated from his or her job, provincial
laws require they continue to accrue a
pension for the statutory notice period,
and most employers will also continue
the accrual during the common-law severance period. But, with the advice of
advisors, many employees request they
be deemed a retiring allowance with
their severance payment so they may
transfer a portion of this to their
RRSPs on a non-taxable basis (amount
depends on years of service before
1996). One of the requirements of
CRA for such designation of a retiring
(1)
Calculation of Commuted Value of $1,000 Monthly Pension for a 50-Year-Old
A. Life expectancy at age 65
19.0 years to age 84
B. Present Value at 5.25% of 1(2) for a term of 19.0 years
12.17
C. Discount for 15 years: 10 years at 5.0% and 5 years at 5.25%
2.10
D. Resulting Factor at age 50 [=B/C]
5.80
E. Commuted Value at age 50 of $1,000 Monthly Pension
[=$1,000 x 12 x D]
$69,600
(1)
simplified; actual method for actuarial calculation differs, but results are similar
(2)
1/12th payable each month
allowance is that there will be no further
accrual of pension. So the employee
loses out on some pension when he
requests this retiring allowance treatment. In some situations, the loss may
not be great and is more than offset by
the financial gain of deferring income
taxes on the portion of the retiring
allowance rolled over to the RRSP. But
we have seen some situations where the
employee lost significant increases in the
commuted value by requesting such
treatment. This is because they were
close to meeting the service criteria for
subsidized early retirement benefits, and
would have received this with the additional service had they not requested a
retiring allowance.
The decision whether to transfer the
commuted value of benefits from a pension plan varies from person to person.
Not all of them apply to each person.
There are situations where the best
advice is to leave the pension in the
plan, and other situations where one is
expected to be financially ahead by taking the transfer. How one will invest the
funds, and the expected investment
returns, is an important consideration,
but not the only one.
Ashley Crozier, FCIA, CFA, is an
independent actuary based in Toronto
with 20 years of experience in pensions
and life insurance.
ashley@crozierfinancial.ca
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