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CAPSA And The CIA – What Were You Thinking?

By: Tom Walker

The Canadian Institute of Actuaries is reviewing its proposal for a new ‘Standard of Practice for Determining Pension Commuted Values.’ Tom Walker, of Mellon, Human Resources & Investor Solutions; explains why a group of actuaries launched a petition against the new standard.

At a time when pension accounting, financial, regulatory, and administrative issues are high profile within the pension industry, the Canadian Institute of Actuaries (CIA), with the endorsement of CAPSA, has introduced a Standard of Practice for Determining Pension Commuted Values. This pending standard greatly increases the volatility and complexity of Defined Benefit (DB) pension plans and, in most market conditions, reduces the commuted value payable to a terminating plan member compared to the current standard which has been in place since 1993. This prompted a petition signed by 54 actuaries which, in accordance with CIA bylaws, has prompted the CIA board to review the pending standard.

In view of CAPSA’s ongoing initiatives to increase uniformity and simplicity in pension legislation across all jurisdictions, the inconsistency of endorsing the pending standard is striking. CAPSA, in a December 9, 2002, letter (which is available at http://www.capsaacor. org/) expressed concerns to the CIA after reviewing the exposure draft for the standard. The interest assumptions and the resulting volatility of both commuted value calculations and solvency valuations were raised as concerns by CAPSA. It expressed additional concerns about the complexity of the calculations and encouraged the CIA to engage in broad consultations with interested parties outside the CIA membership as this issue can have a real effect on individual Canadians and corporate entities.

‘Real Effect On Individual Canadians’

The CAPSA query resulted in changes which, at best, can be characterized as minor. None of these changes addressed, in any material way, the concerns about volatility, complexity, or the “real effect on individual Canadians.” Regardless, in an October 31, 2003 letter (which can also be found on the CAPSA website), CAPSA endorsed the proposed standard.

It remains unclear how CAPSAsees the valid issues it raised as no longer of concern. In terms of complexity and volatility there has been no change from the exposure draft to the pending standard. The prescribed interest rates and the mortality basis have seen minor changes but these changes only partially, and inadequately, address the “real effect on individual Canadians” issue.

The change in commuted values from the current to the pending standard is very significant. Based on a month-to-month analysis for the 10 years ending December 2003, about 80 per cent of the monthly commuted value factors for ages 25 to 44 on non-indexed pensions are smaller than under the current standard. Much more striking is the difference on indexed pensions, which cover most public sector employees. For the 10 years ending December 2003, virtually all of the monthly factors for ages 25 to 44 on indexed pensions are lower than under the current standard. In about two-thirds of the age/month combinations, the reduction in the commuted value factor for an indexed pension is at least 20 per cent. In about onethird of the age/month combinations, the reduction in the commuted value factor for an indexed pension is at least 30 per cent.

The changes in the commuted values are primarily because the underlying philosophy of the standard has been changed from a basis which recognized both the current market (for the first 15 years) and the historical market (after 15 years) to one which recognizes only the current market rates from termination to the end of the mortality table – regardless of age at date of termination or death. By reverting to an historical average, the current basis provides a moderating influence on the volatility of the commuted values for members who terminate or die. This means that the difference in value between two members who terminate within a few months of each other can be more easily explained.

Moderating Influences

The reversion to an historical average also provides a moderating influence on the relative value of benefits for those who receive their commuted value as a result of termination or death versus those who stay in the plan until retirement. Under the pending standard, the relative value of the benefit received by a terminating member, compared to a retiring member, has been reduced significantly. The higher relative value attained by employees who stay until retirement, for the same period of service, has long been a weakness of DB plans. This relative reduction in value is very pronounced in plans which have generous early retirement provisions such as ‘Rule of 90’ or ‘30 and out.’

Both the current and the pending standard increase the market interest rates used to calculate the commuted values by 0.5 per cent for non-indexed pensions. For indexed pensions, the increase under the pending standard is also 0.5 per cent, an increase of 0.25 per cent from the current standard. The impact of this adjustment to the market interest rates is very significant, contributing to a reduction in commuted values. This reduction occurs because the adjustment is now applicable throughout the entire time span of the member calculation rather than just for the first 15 years. The increase in this adjustment on indexed pensions partially accounts for the more dramatic reduction in commuted values for indexed pensions compared to non-indexed pensions. It is this interest rate adjustment which precipitated the petition to the CIA board.

Another concern is that the pending standard will not apply to marriage breakdown calculations. Prior to the development of the current standard (in 1993), the CIA concluded that the same economic assumptions should be used for marriage breakdown calculations and commuted values for pension plans. The introduction of the pending standard appears to have rescinded that position although a task force is being formed to attempt to reconcile the conflicting positions.

The pending standard has many implications beyond the complexity and volatility issues. The proposed changes also raise issues which go to the heart of basic human resource goals and the fundamental choice between DB and Defined Contribution (DC) plans.

Demonstrate The Value

Given the challenges faced by DB sponsors over the past several years, we are at a point where all parties in the pension industry must review all aspects of plan design and regulation and make some fundamental changes. Of critical importance will be the ability for plan sponsors to demonstrate the value provided through their DB plans to all plan members – not just to those who retire after long service.

Hopefully, the CIA board review will result in a decision to stop the implementation of the pending standard. The current standard needs updating but it must be done in a manner which helps DB plan members and sponsors. If a fundamental change in the current standard is required, it should be done in conjunction with overall changes to the DB pension environment rather than as another complicating act in isolation.

Tom Walker is a principal and consulting actuary at Mellon, Human Resources & Investor Solutions.

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