Clients transferring the commuted value (CV) of their defined-benefit (DB) pension plans could soon receive reduced payouts thanks to an updated formula that takes effect Dec. 1.
Some DB plan members, particularly those near the plan’s normal retirement date, might see little or no reduction in CV.
However, “someone terminating in their 40s who doesn’t have many years of service could be looking at a 5% reduction in CV payout,” depending on the pension plan’s features, said William Kennedy, an actuary and senior vice president with Lesniewski Moore Consulting Group Inc. in Toronto.
A notice published in February by actuarial consultancy firm Eckler Ltd. estimated that changes to the retirement date assumption in December’s revised formula might shrink CVs by between 4% and 7% for someone aged 45 in a DB plan with a normal retirement age of 65.
The new formula was developed by the Actuarial Standards Board of the Canadian Institute of Actuaries after a multiyear review process and was set to become effective Aug. 1. In April, at the start of the Covid-19 lockdown, the institute announced it would delay the effective date to Dec. 1. (Target pension arrangement plans, which can reduce benefits to manage their funded status, were allowed to adopt the revised standard earlier.)
The new formula employs a revised retirement date commencement assumption and a market-based interest rate calculation that reflects yield information from provincial and corporate bond indexes, in addition to Government of Canada bond yields.
The impact of these two key revisions on CVs will depend on the plan member’s age, the bond indexes used to calculate the spread, economic conditions at the time of calculation and a plan’s provisions, the Eckler notice stated.
“For plans without early retirement subsidies, the change could have no impact on CVs,” the Eckler notice said. “However, CVs will generally be lower under the new standards for plans with early retirement subsidies; the more generous the [subsidies], the greater the decrease.”
DB plan members who terminate their employment often have the choice of either remaining in the DB plan and receiving regular pension payments when they retire, or transferring a CV out of the plan and either using it to purchase an annuity or taking it as a lump sum — some or all of which might be transferable to a locked-in retirement account.
Lea Koiv, a pension expert and president of Lea Koiv & Associates Inc. in Toronto, said she has been fielding “a lot of queries” about the merit of transferring a CV from a DB plan before Dec. 1.
“I am encountering individuals who are contemplating terminating their employment before the changes come into effect in order to access a CV,” said Koiv, who counsels that such a move would be highly risky and ill-advised.
“The likelihood of being able to join another employer offering a DB plan is low, especially in the private sector,” Koiv said.
Members who recently asked for a CV quote from plan administrators but decide not to commute their pension until the new year might “find out that their CV [quote] has decreased because interest rates have changed a little bit,” Kennedy said.
However, Kennedy suggested the imminent approach of the Dec. 1 effective date, and any potential difference in dollar value of a CV, shouldn’t be a primary factor in deciding whether to take a CV. Using the impending change as a sole impetus would be “bad planning,” he said.
Kennedy said that for many people, remaining in a pension plan is often the better option: “There’s no way a CV transfer is ever going to be able to increase your pension by anything significant unless you’re getting 8% annual compound returns for 15 years.”
Koiv also typically favours clients remaining in a plan or using the CV to purchase a copycat annuity — one that allows a purchaser to match the terms of the pension plan they left — if they’re concerned about the long-term prospects of the DB plan.
“Often, a plan member will want to commute [a DB pension] because of the estate value,” Koiv said. “To me, the more important consideration is having lifelong income.”
Jason Heath, managing director and certified financial planner with Objective Financial Partners Inc. in Markham, Ont., says the decision of whether to take a CV from a DB plan is complicated and highly personal. “It may be one of the biggest financial decisions [a client] makes, along with buying a home,” he said.
When interest rates are low, as they are currently, CVs are high, making the decision to transfer a CV a potentially attractive option. However, amounts withdrawn must be invested to create a future retirement income, Heath said.
“A confident, aggressive investor today may not be as capable or tolerant of risk after they retire or as they age,” Heath said, “so the investment return they think they can earn may be lower than they expect.”
In addition, only a portion of the commuted value amount is typically eligible to be transferred to a locked-in retirement account, with the rest subject to immediate tax.
“If you don’t have RRSP room to offset some of the income inclusion, there can be a lot of tax payable as a result of the commuted value election,” Heath said.
Taking a CV might be suitable for clients with an aggressive investment risk tolerance, shortened life expectancy, a relatively small pension and/or other DB pension income available, either through their own pensions or those of their spouse.
“Taking a commuted value for another pension may allow [a couple] to diversify between annuity income from pensions and investments from locked-in RRSPs,” Heath said.