CIA Annual Meeting
Assemblée annuelle de l’ICA
June 29 & 30, 2006  Les 29 et 30 juin 2006
Ottawa, Ontario
• SERP Commuted Values
• Other SERP Actuarial Issues
Doug Chandler
PEN-22 SERP Pension Session
CIA Annual Meeting  Assemblée annuelle de l’ICA
Typical Situation – Commuted Value
•
•
•
•
only monthly income is specified
scanty documentation
both parties want a lump sum settlement
sponsor and member trust actuary
PEN-22 SERP Pension Session
CIA Annual Meeting  Assemblée annuelle de l’ICA
Standards of Practice
• Commuted Value standard does not apply
(3810.03)
• don’t say it does (3850.06)
• CSOP does apply:
–
–
–
–
unbiased calculations (1740)
assume a tax rate (1710.06)
disclose stipulated assumptions (1720.03)
disclose alternative to extreme assumption (1720.06)
PEN-22 SERP Pension Session
CIA Annual Meeting  Assemblée annuelle de l’ICA
All the Usual CV Issues…
•
•
•
•
mortality
discount rate
future retirement age
marital status at future retirement
And a Couple of Others…
• tax adjustment
• integration with Registered Pension Plan
PEN-22 SERP Pension Session
CIA Annual Meeting  Assemblée annuelle de l’ICA
Adjusting for tax can be a big deal!
Example:
•
•
•
•
•
•
$100,000 per year annual pension
payable immediately at age 60
Joint and 50% Survivor, UP94@2015
$1.4 million without tax adjustment (5% discount rate)
$1.8 million with 40% tax adjustment (3% discount rate)
Even bigger difference for indexed or deferred pensions
$2,000,000
$1,500,000
$1,000,000
$500,000
$No Tax Adjustment
With Tax Adjustment
PEN-22 SERP Pension Session
CIA Annual Meeting  Assemblée annuelle de l’ICA
Employer Perspective
• corporate tax deduction for lump sum
• cost is after-tax cost of capital (or debt)
Employee Perspective
• tax on lump sum
• tax on interest, dividends and capital gains
• no tax on withdrawals from after-tax funds
• broader range of tax strategies
PEN-22 SERP Pension Session
CIA Annual Meeting  Assemblée annuelle de l’ICA
81
78
75
72
69
66
60
84
81
$0
78
$0
75
$50,000
72
$50,000
69
$100,000
66
$100,000
63
$150,000
60
$150,000
63
Non-Registered Funds First
RPP net of tax
Tax on RPP
RRIF net of tax
Cash net of tax
SERP net of tax
Tax on SERP
Tax on RRIF
Tax on Cash
PEN-22 SERP Pension Session
CIA Annual Meeting  Assemblée annuelle de l’ICA
Effective Tax Rate on a
Non-Registered Investment Fund
Less than $35,000
$35,000 to $70,000
Most Efficient
Investment
Strategy
7%
13%
Least Efficient
Investment
Strategy
22%
31%
$70,000 to $120,000
Over $120,000
17%*
20%
39%*
46%
Earnings
* plus OAS clawback after 65
Be sure to validate your assumption with current tax rules and province of employment,
e.g. www.kpmg.ca/en/services/tax/taxratesPersonal.html
PEN-22 SERP Pension Session
CIA Annual Meeting  Assemblée annuelle de l’ICA
Commuted Values and Tax Adjustment
Avoiding the Issue
• Specify commuted value basis in plan document
• Take direction from client (stipulated
assumption)
• Explain the effect of taxes and report a range
PEN-22 SERP Pension Session
CIA Annual Meeting  Assemblée annuelle de l’ICA
Commuted Values and Tax Adjustment
Examples of Specified Basis
•
•
•
•
same basis as RPP (no tax adjustment)
purchase price of prescribed annuity
discount rate reduced by a tax rate of x%
commuted values at y% fixed
PEN-22 SERP Pension Session
CIA Annual Meeting  Assemblée annuelle de l’ICA
Commuted Value Assumptions Required
for Explicit Tax Adjustment
• Asset mix
• Equity turnover rate
• Tax rates (for lump sum, monthly pension, and
income on various asset classes)
PEN-22 SERP Pension Session
CIA Annual Meeting  Assemblée annuelle de l’ICA
Example – Integration with RPP
$4,000
• Annual normal retirement
benefit is $5,000 per year
of service
$3,000
• Plan reduction is 5%/yr
from 65
$2,500
$2,000
$1,500
• Plan indexing is ad hoc
SERP
RPP
$1,000
• RPP pays ITA maximum
• Retirement at 60 in 2009
$500
74
72
70
68
66
64
62
$0
60
Annual Pension per Year of Service
$3,500
Age
PEN-22 SERP Pension Session
CIA Annual Meeting  Assemblée annuelle de l’ICA
Other Types of SERP “work”
• funding valuations – Retirement Compensation Arrangement
• determining the face amount of a Letter Of Credit
• plan design cost studies
• corporate accounting – CICA3461, FAS87, IAS19
PEN-22 SERP Pension Session
CIA Annual Meeting  Assemblée annuelle de l’ICA
50% RCA Tax Rate

intended to prevent tax advantage (at 1986 rates)
does not reflect recent changes in corporate and
personal tax rates, capital gains tax inclusion rate,
dividend tax credits


a neutral rate today would be about 30%
many more employers would fund RCA’s if the tax
rate were lowered

http://www.watsonwyatt.com//canadaenglish/news/pdf/WW_Submission_2005_Federal_Pre-Budget.pdf
PEN-22 SERP Pension Session
CIA Annual Meeting  Assemblée annuelle de l’ICA
Retirement Compensation Arrangements
Reason for Funding
Valuation Basis
Eliminate Balance Sheet Liability

Accounting Basis
Stable Contribution Rate

Going Concern
SERP is part of a registered plan

Going Concern and
Solvency
Tax Deduction for Employee Contributions 
Benefit Security

PEN-22 SERP Pension Session
Matching
Settlement Cost
CIA Annual Meeting  Assemblée annuelle de l’ICA
Letters of Credit
 can be a tax-effective alternative to RCA funding

require actuarial report to determine face amount

same problems as commuted values:
- no specified basis for settlement
- optimal tax adjustment depends on plan member
PEN-22 SERP Pension Session
CIA Annual Meeting  Assemblée annuelle de l’ICA
Letter of Credit Valuation

be aware of annual cycle deadlines and roles:
-
sponsor
-
trustee
-
bank
- Administrator

you’re telling them how much insurance to buy

face amount must cover triggering event any time in the year
-
fluctuations in interest rates
-
mid-year cliff vesting
-
new members
-
bonuses that boost final average pay
PEN-22 SERP Pension Session
CIA Annual Meeting  Assemblée annuelle de l’ICA
Letters of Credit
Don’t forget about the Refundable Tax Account
$2,500,000
Amount required to Settle
$2,000,000
Face amount of LC
$1,500,000
$1,000,000
$500,000
PEN-22 SERP Pension Session
95
10
0
10
5
Age
90
85
80
75
70
65
60
55
50
45
40
$0
CIA Annual Meeting  Assemblée annuelle de l’ICA
Letter of Credit Valuations:
Integration with RPP
typical SERP combines with RPP to pay “whatever the RPP would
pay without tax limits”


hypothetical wind-up scenario – both plans
-
does legislated grow-in increase or decrease SERP obligation?
if surplus in the RPP is distributed through indexing or other
improvements, do those improvements increase or decrease the
SERP obligation?
-
PEN-22 SERP Pension Session
CIA Annual Meeting  Assemblée annuelle de l’ICA
Cost Comparisons
Approach to security
Additional
cost
RCA for actives
80%
LOC for actives
40%
RCA for retirees
33%
LOC for retirees
15%
Lump Sum Settlement with 50% marginal tax
33%
Lump Sum Settlement with 20% marginal tax
15%
Prescribed Annuity
33%
Figures are for illustration only – do your own calculations and sensitivity testing
PEN-22 SERP Pension Session
CIA Annual Meeting  Assemblée annuelle de l’ICA
Questions about Cost Comparisons
1. Should the LOC fee be expensed on a cash basis or an accrual
basis?
2. What about trustee and administration fees?
3. What is the going concern value of an RTA balance that will never
be recovered?
4. How do you factor in corporate tax costs?
5. What about life insurance products?
6. What is the actuary’s role in conflicts between the interests of
executives and the interests of the company?
PEN-22 SERP Pension Session
CIA Annual Meeting  Assemblée annuelle de l’ICA
Questions about Corporate Accounting
1. What retirement age should you use?
• most likely (earliest unreduced)
• most expensive (could be 65)
•scale from 55 to 65
2. Should you discount for forfeiture on early termination?
3. How do you account for an increase in the tax limits?
5. Should SERP and RPP assumptions be the same?
6. Should you disclose the sensitivity to salary and bonus
changes?
7. Do you need to measure the extra SERP liability arising from
individual salary variations?
PEN-22 SERP Pension Session