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.
It’s a crime
Share it fairly but don’t take a slice of my pie”
In a recent commentary I explained why I thought the actuarial profession shouldn’t be in the business of setting the rules for commuted values and why I think it’s the government’s job to make up a number that will surely be wrong in almost every case. Ontario blinked this time around and has taken back the job for calculating the values for target pension arrangements by overtly saying that they don’t accept the standards set by the actuarial profession. I think they will come to regret this move.
At the heart of the problem is the fact that there is no right answer for the fair lump-sum value in exchange for a series of payments contingent on one individual’s life. The entire reason that the life insurance industry has existed for 300+ years is because you need to pool these types of risks to get a fair price ‘on average’ by using the law of large numbers.
So, what is all the excitement about with the new standards for target pension arrangements? The short answer is that after decades of hard thinking a majority of actuaries now see a different fair value for pension promises under target pension arrangements than for the pension promises under single-employer pension plans. More importantly, actuaries have bifurcated the standards between the decisions that actuaries should make and decisions that clearly belong outside the profession. Since historically the government did not want to be involved in any decisions (other than gender), the actuarial profession has handed some critical decisions back to the plan administrators that have a fiduciary duty to plan members.
Life’s Not Fair
Increasingly, attention is being paid to the issue of inter-generational equity in target pension arrangements. The idea that one generation of workers would be asked to fund benefits for another generation is considered by many to be unfair. But not everyone considers it unfair and in fact older workers in some organizations believe that the next generation should be grateful for the job that is being handed down to them and should be happy to contribute to the retirement of the worker that came before them.
Inter-generational transfers of wealth in pension plans is simply a form of cross-subsidization that is a foundation of the defined benefit plan. DB plans have always operated with all contributions and investment income comingled to pay all the benefits promised under the pension plan. There was never a promise that each plan participant would receive the accumulated value of their contributions – if that were the case it would be a defined contribution plan.
The two-year vesting that arose in the 1980s was a recognition that the old 45+10 vesting rules just weren’t fair. To me, overly generous early retirement provisions are an unhealthy cross-subsidization from those that need to work longer to those who are already lucky enough to retire early.
Fair is Fair
If you spend some time studying socialism, you will find the roots of the idea that each individual doesn’t need to get out exactly what they put into the system and that serving the collective good creates a greater society for all. However, as generations pass and as communities become larger and less closely connected, we are seeing collectivism decline. In my experience, while the best workforces have a ‘team first’ attitude, there is a limit to the willingness of workers to subsidize their co-workers.
Cross-subsidization works when the subsidies are small, where no one really knows in advance who will be the winners and losers, or where there is an expectation over the long run that what you do to help someone today will come back to you in the future with someone helping you. In this latter environment, at one end of the spectrum some like clear rules on the now popular ‘quid-pro-quo’ while at the other end is those who just believe in Karma.
So how does this rambling by me relate to commuted values? The traditional rules for commuted values were first established by the Canadian Institute of Actuaries in 1986 and modified several times over the years to reflect our better understanding of the capital markets and our greater computing power allowing for more complex formulas. The truth is that there is no ‘fair value’, as an economist would define it, for a defined benefit pension; so, we are left to guess at a value that might be close to fair so that an employer and employee can exchange cash for a deferred pension. Portability was a nice idea in theory but has forced parties to the transaction to accept an arbitrary settlement that at times has been clearly unfair to one side or the other.
The New Frontier
Dean has spelled out key details of this new commuted value standard earlier this year in his commentary. I won’t go back over all of it but want to focus on the completely new thinking for target pension arrangements.
In a nutshell, TPAs can move away from the guess of actuaries of the ‘fair value’ of a pension and move towards a guess of actuaries on the ‘amount of assets’ that should be set aside to fund the pension promise. If you aren’t an actuary you should be asking, aren’t these the same thing? And while many actuaries think the answer should be yes – there are many that think the answer should be no. To be brief, the ‘fair value’ is considered the current market value (the standard calls it ‘economic value’) based on today’s capital markets, while the assets to be set aside to fund the promise are based upon a long-term view of how much you need today (when properly invested) to get to the right end result. These two values diverge because in most periods the short-term economics diverge from the long-term world that actuaries would like to imagine.
Who Decides Fair?
In the details, the trustees/administrators of a TPAs have been given some options in deciding how the commuted value will be calculated. That is right – as much work as actuaries have done to come up with a single fair number for single-employer DB plans, for TPAs, we are heading to a world where two identical pension plans with different administrators might be different by 10% or more depending on the choices made by the plan administrator. But to be clear – this wide range is not a bug in the system but in fact a late admission by the actuarial profession that we just can’t give a single answer that applies in all cases.
As noted in my earlier commentary this is the right way to go. After all, there is no right answer and so instead of actuaries making the political compromises the actuarial profession is rightly putting those compromises in the hands of administrators that have a fiduciary duty to plan members. Sadly, no plan member is going to be able to know if they are being treated fairly unless they know how to use some sophisticated software, or they have their own personal actuary or an unbiased investment/insurance advisor to help them with the math.
There are a number of ‘options’ that administrators will have to consider – but I will just tackle two here. First, the option to reduce the value of the commuted value by the level of funding in the pension plan. Long discussed by the industry, I think this is a good rule since if assets are insufficient permanently then benefits will have to be reduced at some later date, so someone terminating shouldn’t get out the door with 100 cents on the dollar. Back to cross-subsidization, in the old rules, members of an underfunded plan are always subsidizing those that are leaving and taking 100% of their ‘fair value’. Of course, to be fair then you probably need to increase the commuted value when the plan is over funded. This change in the rules for commuted values recognizes that the old rule really should have only applied to pension plans where the benefits were guaranteed by a sponsor or a guarantee fund beyond the current level of assets.
The second option that I find interesting is that the rules state that ‘margins for adverse deviations’ used to fund the pension promise would not be included in the commuted value unless the plan or the law requires its inclusion. Why did they do this? As I understand the logic – the margin expected to fund the promise is ‘extra’ beyond the true value of the pension – so if someone is departing, they should only get the true value and not the extra margin that has been built up.
There are two flaws in this theory. First, if a pension fund needs a margin to reflect the fact that the ‘target assets’ might not be enough – doesn’t an individual need a margin too? Second, where did the assets that support the margin come from in the first place? Unless the pension plan is funded by magic then the funds came from contributions by plan members (directly or indirectly through employer contributions). This second point comes back to my concern with cross-subsidization. Are we comfortable having members that transfer commuted values ALWAYS subsidizing those that stay? Of course, the margin question will come up again as plans go past maturity and into decline – who gets to keep the margins for retirees that die? Sorry tangent – don’t start me….
The reality of the ‘no margin in the commuted value’ design is that I can be a member of the TPA for as long as I want and help build up a margin to protect against an uncertain future that all pension savings face – but if I want to leave the plan I leave the margin behind. Of course, if the member doesn’t like the deal, they can leave their deferred pension with the plan and call back when they are ready to retire. This however is somewhat of a contradiction to the goal of portability to let workers keep their pension assets with them and to relieve administrators of tracking workers that are long gone.
The actuarial profession has done something good here. They have correctly put into the hands of others the decisions for which there is no clear answer. What I can hope is that this message will end up in the hands of the trustees/administrators of the TPAs and that it will give them pause to think about the fact that they have the choice to take the high road and voluntarily include the margin in the commuted value instead of taking the road that says ‘the rules say we are allowed to leave margins out’.
The legislators and regulators may want to save everyone some heartache and amend the legislation to say that the margins must be included. Maybe this is why Ontario has stepped between the actuarial profession and plan administrators to do just that. We will be watching.