Are You Prepared For Commuted Value Standards Changes?
By: John R. Richards
February 1, 2005, a new standard for determining pension commuted values goes into effect. John R. Richards, of Avalon Actuarial Consulting, explains what plan sponsors need to do.
Anew Standard of Practice for Determining Pension Commuted Values (the ‘Standard’) was issued by the Canadian Institute of Actuaries on July 14, 2004, effectively replacing the current Recommendations for the Computation of Transfer Values from Registered Pension Plans (the ‘Recommendations’). The effective date of the new Standard is February 1, 2005.
Whether by direct or indirect reference in the various provincial pension acts, the Recommendations have formed, since 1993, the minimum basis for transfer values out of Defined Benefit pension plans. The result is most, if not all, DB plans in Canada will be affected by this change. The solvency position of ongoing plans will also be impacted.
The Standard applies when determining lump sum values to be paid out of a registered pension plan in lieu of an immediate or deferred pension on death, termination, reciprocal agreements establishing a Defined Contribution lump sum, or in certain legislated circumstances on marriage breakdown.
The Standard does not apply in more specialized circumstances such as under non-registered pension arrangements, conversions, shortened life expectancies, discretionary commutations of pensions in payment, and in valuing pensions on marriage breakdown. These situations form many of the day-to-day administrative tasks performed by the plan administrator.
So how is the ‘new’ Standard different from the ‘old’ Recommendations?
The Recommendations were last updated back in 1993. Since that time, there have been changes in the financial markets which affect the value of immediate and deferred pensions. Two significant adjustments have been reflected in the Standard.
The market discount rate assumption has been changed to reflect the use of two variable interest rates; one interest rate for the first 10 years and a second rate thereafter. Each rate is based on the market yield of a specific Government of Canada bond series. Indexing provisions of the plan are reflected. The previous Recommendations mandated the use of a single variable interest rate with a fixed rate applying after 15 years.
The mortality basis has been updated to a more current mortality table – UP-94 with projected improvements to 2015.
It is worth noting that the change will result in higher volatility in commuted value results to members, as well as, in general, in higher commuted values for male members (a result that I particularly am enamored with as the new mortality tables expect males to live longer). Based on current rates under the new Standard, pension plans with indexing provisions will generally see a reduction in commuted values.
The Standard is to be applied effective February 1, 2005, and early implementation is prohibited! Although not specified in the Standard, it would seem reasonable to assume that if the ‘computation date’ – for example, the date of termination – is before February 1, 2005, the Recommendations would apply. The Recommendations are formally written into the law in several provinces (Ontario, Quebec, and New Brunswick) and will require amendments to the provincial pension acts. A member who terminates after February 1, 2005, may be, by virtue of his or her geographical work location, treated differently if the specific legislation has not been updated by February 1, 2005. It is anticipated that the respective acts will all be updated eventually.
From a pension plan sponsor’s perspective, most pension plans require the administrator or the actuary to adopt a distinct Commuted Value Basis within the formal plan document. A good practice is to actually document such a Basis. An updated document, along with implementation decisions, should be developed prior to February 1, 2005, to ensure a smooth transition. The basic changes prescribed by the new Standard must be reflected, but additional consideration should be given:
- to the re-computation features of the termination benefit around the time of the changeover. Consistency between previous and current calculations and between plan members should be reviewed. The confusion which may occur can be best explained by way of an example. A plan administrator may need to calculate three termination benefits on February 6, 2005, one for a member who terminated on January 29, 2005, where the value would be determined by the Recommendations, one for a member who terminated on February 5, 2005, where the value would be determined by the Standards, and one for another member who terminated June 29, 2004, and did not return his/her previous form in a timely manner and a re-offer of the commuted value is made.
- in preparation of sample ‘projected’ calculations. These are commonly prepared for members who are considering taking a benefit from the plan. Care should be taken in developing the communication for entitlements which span the February 1, 2005, effective date to limit surprises as a result of differences between the projected calculation and the actual calculation.
- to the creation of a different ‘most valuable age’ for early retirement calculations. This tends to be identified in the Commuted Value Basis.
In any event, a full review of the calculations and communication of transfer values in the day-to-day administration of the plan should be undertaken. Areas that should be addressed include:
- Old administration systems may be based on the old tables and old functions. Although it may be simple to update to new interest rates and mortality tables, the fact that the second interest rate is variable may complicate older programming codes or functions. The second interest rate will apply after 10 years (not 15 years as before), and this may cause programming issues as well.
- Update hard-coded annuity tables. Some plans are administered by hand (or even by computer) using pre-determined tables of annuity factors and the new Standard will call for these tables to be updated. A different table may currently be used for each initial interest rate depending on the month, with the knowledge that the second interest rate is fixed. Under the new Standards both rates are variable, requiring significantly more potential interest rate combinations and many more predetermined tables to be generated.
- Pension administration model option forms and other member communication material may refer to the Recommendations by name, or the old methods and interest rates. A thorough review should be completed, including any online tools that are available to members, to ensure that any required updates are made.
- The annual statement and the process used to generate the information may need to be updated. Recent changes in the Quebec legislation require the inclusion of a commuted value on the statement, and a review of the method and timing of application underlying the calculation should be considered.
Funding May Be Affected
The funding of the pension plan may be affected by the new Standards. Many plans today are subject to the provincial solvency regulations, which are based on commuted values. Any actuarial valuation with an effective date on or after February 1, 2005, will most likely be impacted by the changes and it is important to be aware of the financial health of the plan. Additional volatility in results can be expected.
The impact of the new Standards of Practice for Determining Pension Commuted Values will be felt by all DB pension plan sponsors and administrators and the sooner that planning for the changes is considered, the smoother the transition will be.
John R. Richards is vice-president of Avalon Actuarial Consulting Inc.
- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -