A Perspective on Commuted Values

Editor’s Note:  This commentary was written before the April 6, 2020 announcement by the Actuarial Standards Board of the decision to delay the implementation for the new commuted value standards to ‘not earlier than December 1, 2020’.  However, early implementation of the standard for target pension arrangements is still permitted.

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“I am so smart! S-M-R-T… I mean S-M-A-R-T!”

Homer Simpson

For years I have argued that the actuarial profession should not be in the business of setting standards for commuted values (I have also argued that we shouldn’t be in the business of setting standards for ‘annuity proxies’ for similar reason, but that is a rant for another day).

Back up – what is a commuted value?

Commuted values are the hypothetical lump-sum value of a series of monthly/annual pension payments payable for a lifetime (or a joint lifetime).  In the good old days, if you were promised a pension then the pension plan delivered those payments when you finally retired.  But in the 1980s, as pension reform took hold in Canada, legislators decided that a member of a pension plan should be able to terminate their pension contract with the pension fund at the time their employment contract was terminated with their employer which was often the pension plan sponsor.  This sounds fantastic in theory – someone no longer connected to the employer shouldn’t have to remain connected to the pension plan sponsored by that employer.

However, as legislation was being drafted, governments came to realize that they needed to tell sponsors how to calculate commuted values ‘in the prescribed manner’.  Somehow in Canada, the Canadian Institute of Actuaries was drawn into the project.  After all, who other than actuaries are best suited to figure out the answer to such a complicated question?

Setting the Standard

What could go wrong in letting someone transfer the fair value of their future monthly pension to an RRSP or another employer’s pension plan?  Well the problem starts from the beginning with the word fair.  The value of a series of monthly payments payable for someone’s lifetime, to state the obvious, varies significantly on how long that lifetime will be, which is correlated (but not precisely) to personal health combined with family medical history.  Commuted values can also vary significantly based upon marital status and the date of early retirement where plans offer ‘subsidies’ of one sort or another.  And the mother of all political hot potatoes – gender is a big factor too.  Finally, you need to have some idea of investment returns for the next 30, 50, or 70 years.

So, when the first commuted value standard was created in 1986 the actuaries did their best – an interest rate taken from government bonds and an assumption that after 15 years the most reasonable estimate would be an investment return of 6% per annum.  We should spend some time laughing at the idea that in the absence of better data we were happy to assume that sooner or later bond yields would return to some sort of average – mean reversion at its finest.  Governments bit the bullet and decided that gender would not be considered and as a result for almost all pension plans females get something less than fair and males get the reward from woke public policy.  Except in Quebec where some smart folks figured out that women would need that extra cash because they will probably live longer and came to a different conclusion on fair.

I have lost track of how many updates the actuarial profession has made to the standard.  Each time around there are many voices at the table.  Many regulators like systems that produce ‘high’ values since their goal is to protect the members while plan sponsors are seen to have endlessly deep pockets to pay whatever it takes to be sure we aren’t being ‘unfair’.  Actuaries that work for plan sponsors, investment firms, or sell annuities all have views – not always the same view.  Already there are complaints that the new standards are unnecessarily complex and, in some situations, don’t make sense.  The Actuarial Standards Board, already fielding complaints about system programming changes and an absence of education material with examples, is considering delay the effective date of the standard from August 1st to later in 2020 – but as far as I can tell, 2020 for sure.

At this point in my commentary you are probably getting a sense of why I think it is a fool’s errand to try to solve the question of what a fair commuted value looks like.

Getting Smarter

In the latest round there have again been changes to try to be more accurate in calculating the fair value that is unknown to start with.  Dean has spelled out the details last month in his commentary on the standard.

Of interest to the profession, regulators, as well as sponsors and members of target benefit plans (now called ‘target pension arrangements’) are the new rules around plans where the sponsor does not commit to guaranteeing the benefits but rather commits to a rate of contribution.  I won’t go into my thoughts on those new standards here, but I will simply acknowledge that this update is a very thoughtful reflection on the difference in value between different types of pension guarantees.  The actuarial profession has done something good here.  They have correctly put into the hands of plan administrators (i.e. boards of trustees) some of the decisions about what is ‘fair’.

Interestingly, the legislators in Ontario weren’t comfortable with the uncertainty of what the new standards would say for Target Pension Arrangements and have already changed the rules so that the single-employer commuted value rules for ‘guaranteed pensions’ still apply to target benefit plans (at least for a while longer).  Gotcha – government is finally admitting that ‘fair’ is a political decision and not an actuarial calculation.  It will be interesting to see if other provinces follow Ontario’s lead.

Perhaps it won’t be long now before the actuarial profession gets out the business of setting these standards and just leaves legislators and regulators with the burden to decide what is fair – a burden that they should have owned from the beginning. 

Joe Nunes
Joe Nunes
Joseph Nunes, Co-founder and Executive Chairman of Actuarial Solutions Inc., has practiced in the area of pensions and retiree health plans for over 30 years. He has experience with many types of plans including single-employer, multi-employer, private sector, government, unionized, non-unionized, as well as registered and non-registered executive plans.

4 Comments

  1. Avatar Mike Duggan says:

    Thanks, Joe. A common sense approach is certainly welcome. Unfortunately, political decisions often absent common sense in decisions. It seems that Registered Pension Plans are no longer sacred, but rather subject to the whims of politics.

  2. Avatar Pat Johnston says:

    Alberta has gone the other way, at least for three of its public sector plans. For these plans, effective April 1, 2020, it is legislated that the accrued benefits can never be reduced (so is not a target benefit plan), but the commuted value basis for these public sector plans will be determined on the going concern funding basis, resulting in a 60-70% reduction in commuted values for young, short-service employees and a 30% reduction in commuted values for those close to early retirement age.

  3. Avatar Pat Johnston says:

    Regarding the concern about the actuarial profession setting the commuted value basis, I fully agree. There is no “natural” reason for a pension plan, which is providing a promise of a lifetime pension to the individual, to provide a lump sum alternative to a terminating member. This obligation is a mandated requirement by pension legislation. Having provided for this CV entitlement, however, it comes down to the basis (thus the underlying objective) for determining the CV under such legislated requirement. Unfortunately, those who made the law providing the CV option left it to the actuarial profession to have full discretion on what the CV was supposed to represent. Initially the underlying premise for the CV was the amount of funds the member would need to reinvest to provide the expected future pension payments. In the early 2000s, the entire underlying premise was changed to what value the market might put on the “pension asset”. Every few years the profession keeps tweaking its attempt to mathematically represent the value that the market would apply. The problem, as I see it, is that it shouldn’t be the actuarial profession making the decision of the underlying premise in the first place – it should be the legislators. Should the CV be the amount of funds that the member needs to reasonably be able to reinvest and provide the expected pension payments? Should it be a proxy of the value the market would put on the asset? Should it be some other underlying basis of determination? This question of underlying basis is one that the legislators who mandate a CV option in the first place should answer. This underlying principle shouldn’t be decided on, and/or changed, by a small committee in the actuarial profession.

  4. Avatar Roto says:

    When the retirement savings world was being assessed by the Regulators in Ontario, there was a demand from the financial industry to free up these pension assets to some degree. The changes to RRSP’s and DC plans that could no longer offer decummulation options in 1978 was a driver of these although now the demand is to re-allow such programs.

    In any event, the situation in review meant that plan sponsors/administrators would be able to commute the pension and distribute the money. The concept of course was that the amount being transferred should be enough that the individual could turn around and buy the same defined benefit from an insurer. The problem of course was that with many insurers all competing for business and assets the cost to buy the annuity would vary greatly.

    We also had the insurance company legislation which required the insurers to invest their assets in a manner to protect those insured which set out some long term standards. So how was the plan sponsor to determine the right CV when so much volatility/ variability existed.

    The solution, have the actuaries review the annuity market and come up with a formula that emulated/approximated the amount it would take to purchase the same pension in the market, providing all plan sponsors with an appropriate and reasonable method to commute pensions.

    Of course setting the standard to a number which looked like the amount that a person could use to immediately buy the same pension from an insurer seems to have disappeared. In a recent review/test. 4 insurers were asked how much would roughly $300,000 would buy for a 65 year old male. The answers (from the highest to the lowest) provided differed by almost $125 a month. The money would be transferred from a DB plan, the promised benefit in the DB plan was just under $100 more than the highest number provided by the insurers.

    The answer maybe was that the insurance industry should have been required to set a standard so there would not be variability. Of course it would then be the actuaries at the insurers setting the standard. And such may create other issues for plan sponsors who wished to have more aggressive actuarial assumptions in their valuations.

    As to the equity issue, it was and continues to be an item, the view was if a male and a female had the same job and earnings history over their career and were retiring at the same time from a DB plan, their pensions would be the same. If they took out the CV, the female would get a higher transfer. However, in a DC plan, the two individuals with the same amount of assets would end up with a different lifetime pension. This was not “equitable” although actuarially correct.

    The true intent of the legislation was to address the DC so called inequity but applying over DB plans caused other issues which have worsened overtime. But that is another story.

    In the end, many may be best to leave their money in the DB plan which may not be to the liking of the plan sponsor wishing to reduce admin costs and overall liabilities.

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