New Commuted Value Standards – The Fair Value of a Pension
As Actuaries, early in our careers we learn the concept of a commuted value. This is the lump-sum payment paid to terminating (and sometimes retiring) members in exchange for a series of future pension payments from the pension plan. It seems like a simple concept, but determining a commuted value is difficult. You are attempting to provide a fair trade for a series of future payments given many unknowns. To this end, the Canadian Institute of Actuaries (“CIA”) has developed and put forth standards of practice for how a commuted value should be determined, and pension laws and regulations have generally accepted these standards be followed.
Early on in my career, I didn’t think much of it. These “rules” were established long before my working career, and thou shalt calculate a commuted value according to such rules. What is refreshing to see as I’ve moved forward in my career is that there is always a reason for the rules, and that actuaries are always thinking about them from a fresh perspective given the changing economic, legislative and social landscape. Is the way we have always done things the right way? Are there new ways to look at things? New tools we can employ? New needs that are no longer being met?
The Actuarial Standards Board (“ASB”) is an independent group responsible for setting the standards of practice in Canada. The ASB is committed to conducting general reviews of all parts of the standards of practice every few years, and over the past several years they established a Designated Group to review the standards of practice for commuted values.
At the end of July, the ASB released an Exposure Draft on amendments to the standards for pension commuted values. While the changes recommended in this exposure draft are not yet final, it is likely that these changes will be implemented in the coming year or so, and these changes may have significant implications for plan members, sponsors and other affected parties.
There are two key changes to the standards that will likely have the most impact:
Multi-Employer and Target Benefit Plans
A new section of the commuted value standards has been added which applies to target benefit and multi-employer plans. Commuted values calculated under these new standards may change significantly for these types of plans as the new standards require the commuted value to be calculated using a plan’s going-concern assumptions, and are further adjusted to reflect the funded ratio of the plan. This new approach attempts to allocate a reasonable share of plan assets to those members who terminate and elect to transfer their share of assets from the pension fund.
The rationale here is that these types of plans contemplate a potential reduction in accrued pensions for members that could occur while the plan is ongoing, which is different from a single employer defined benefit pension plan where benefits are not permitted to be reduced while the plan is ongoing. In general, commuted values for target benefit and multi-employer plans will be much lower than they otherwise may have been in the past for plans that are not fully funded.
In my view, this is a welcome change since the benefits ultimately payable from these plans will depend on the funded status of the plan. It is inequitable to provide terminating members with their full benefit entitlement when members who do not elect (or are not entitled to) such a commuted value may not receive their full benefit in the future.
The standards outline how the commuted value interest rates should be calculated. Without going into too many technical details, commuted value interest rates are determined in reference to the yields on long-term government bonds, with an adjustment for liquidity (since pension plans are much less liquid than government bonds). Historically, this liquidity adjustment has been a flat rate, but the proposed changes include a shift to a market-based adjustment for liquidity.
The ASB back-tested their proposed approach on commuted value rates over the last 10 plus years, and the average discount rates over this period were generally (but not always) slightly higher compared to the current methodology – in particular over the past 7 years. Thus, if the recent economic environment is to continue, we can expect slightly higher commuted value interest rates, which means lower commuted value payouts. This would be a welcome change for plan sponsors, and a less welcome change for those plan members who want to transfer their commuted value entitlement from the plan.
I note that not only will this impact the commuted values paid to plan members, but it will also impact solvency liabilities – at least to the extent that solvency continues to be a driver in the funding of a pension plan (see our client memo, dated May 23, 2017 for more details on the upcoming changes to the funding framework for Ontario pension plans).
I’ll say it again, determining a commuted value is difficult. It is impossible to model this value perfectly, and there must be a balance between precision and simplicity. I personally believe that the overarching goal in determining this value should be fairness. And I think that these new changes move us one step closer to equality for plan members, plan sponsors, and other affected parties.