PRELIMINARY REPORT THE PHILOSOPHY UNDERLYING THE DETERMINATION OF LUMP-SUM TRANSFER VALUES FROM PENSION PLANS TASK FORCE ON TRANSFER VALUES

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1 PRELIMINARY REPORT THE PHILOSOPHY UNDERLYING THE DETERMINATION OF LUMP-SUM TRANSFER VALUES FROM PENSION PLANS TASK FORCE ON TRANSFER VALUES OCTOBER Canadian Institute of Actuaries Cette publication est disponible en français Canadian Institute of Actuaries x Institut Canadien des Actuaires

2 The Philosophy Underlying the Determination of Lump-Sum Transfer Values from Pension Plans Based on pension legislation adopted in the late 1980 s, employer-sponsored pension plans in Canada offer a lump-sum transfer alternative to a vested deferred pension for a member who leaves a pension plan before being eligible for retirement. The transfer value is generally determined in accordance with the Canadian Institute of Actuaries Recommendations for the Computation of Transfer Values from Registered Pension Plans, last amended effective September 1, Since 1993, a new mortality table has been released, interest rates have plummeted, interest rate spreads have narrowed, and the prevalence of insured annuities for deferred pensions has declined. Not surprisingly, actuaries and others are questioning whether the 1993 recommendations need to be updated. Before we can determine whether we need an update or the details of any potential update, we need to review and re-assess the philosophy or objectives underlying the determination of transfer values. This article presents several alternate philosophies reviewed by the Canadian Institute of Actuaries Task Force on Transfer Values, along with a proposed underlying philosophy, for discussion with various interested parties. Equity Considerations The transfer value basis affects a number of parties, including: a) a member who receives a transfer value from a pension plan; b) the pension plan which pays the transfer value to the member; c) the spouse of a member under a pension splitting arrangement, if the value of the member s pension has been based on assumptions established for transfer values, d) a plan member whose pension is split with a spouse as in item c); e) a member whose contributions with interest or account balance are converted to a defined benefit pension using the transfer value assumptions; and f) a plan providing defined benefit entitlements to members based on a conversion of account balances to pensions using the transfer value assumptions. In each case, there are two parties affected by a transfer value calculation, a seller and a buyer. Plan members are buyers in some situations, and sellers in other situations. To be fair to all affected parties, the transfer value basis will need to be neutral. Therefore, the basis should reflect best-estimate assumptions, without bias or margins to provide for potential adverse deviations. 1

3 Risk Considerations To start, we need to consider the issue of risk and the likelihood that the pension plan member will actually receive the pension which has been promised. To illustrate the risk issue, think of the analogy to a bond. A bond issued by the federal government has a higher value than the same bond (i.e., the same series of coupon payments and redemption value) if issued by a corporation. The corporate bond is discounted at a higher rate than the government bond to account for the risk involved. This is illustrated in the table below: Table 1 Annualized Yields on Long-Term (10+ Years) Bonds as at December 31, 1997 Bond Type Risk-Free Yield Risk Discount Total Yield Value of a Benchmark Bond 1 Canadas 5.96% 0.00% 5.96% $ Provincials 5.96% 0.34% 6.29% $97.60 AA Bonds 5.96% 0.45% 6.41% $96.13 Average Corporates 5.96% 0.56% 6.52% $94.81 BBB Bonds 5.96% 1.20% 7.16% $87.85 Turning back to the risk associated with a member s pension from a Canadian pension plan, the risk is highly dependent on a number of factors, including: a) the funding status of the plan (i.e. the funded status on a wind-up basis and the ongoing funding policy); b) the terms of the applicable Pension Benefits Act (i.e., whether and how quickly any wind-up unfunded liability must be amortized, whether such amortization payments must continue after plan wind-up, whether benefits are guaranteed by a government, etc.); and c) the risk that the employer will go bankrupt or otherwise cease to be in business. 2 It is noteworthy, that in general, as long as the employer continues in existence and makes all required payments to the pension plan, the member will receive the full amount or value of his or her pension entitlements. As a result, the risk associated with a plan member s pension is related to the risk of the employer being able to continue in operation. Many actuaries believe that, for an average Canadian pension plan, the risk associated with the member s pension is somewhat less than the risk associated with average corporate bonds but perhaps equal or more than the risk associated with provincial government bonds. Obviously, certain plan members have pensions which involve much more risk than certain other members pensions. For practical reasons, any general commuted value basis can, at best, reflect average risk characteristics. As is evident from Table 1, in order to give a plan member a lump-sum amount with the same value as the pension payable from the plan, the risk characteristics of the pension must be considered. 1 The benchmark bond is a hypothetical 25-year bond with a 6% coupon. 2 Multi-employer plans involve a somewhat different risk, namely that the plan will cease to exist or that benefit levels will need to be reduced. 2

4 Alternate Principle 1: Commuted Values Based on Individual Annuity Purchase Rates Under the individual annuity purchase principle, the transfer value available to a pension plan member would be the member s cost of buying an insured annuity to replace the vested deferred pension. This is a very intuitive, simple and attractive principle, which would be readily accepted by most pension plan members and regulators. Unfortunately, there are very serious problems with the individual annuity purchase basis, as indicated below: a) There is no individual annuity market for deferred pensions, especially in the case of indexed pensions and deferred pensions payable far into the future. This problem is sufficiently serious to call into question the individual annuity purchase basis, even if there were no other problems involved. b) As outlined in the section regarding risk, the value of an insured annuity may differ materially from the value of a pension payable from the pension plan, depending on the risk associated with the insured annuity. After considering that the cost of an insured annuity includes the insurer s profit margin and provision for future administrative expenses, it is very likely that the cost of the insured annuity exceeds other measures of the value of the pension. c) Members who elect a lump-sum transfer generally are planning to invest the lump-sum in an RRSP until some future date when the balance will be annuitized. Current purchase rates for deferred annuities are not relevant to them. d) Individual annuity costs are higher than the employer s cost of providing a deferred pension, especially if equities out-perform fixed income securities in the long run. Thus, the individual annuity purchase basis would increase the employer s cost of providing vested pensions. This was probably not an intended consequence of pension reform, since portability was not intended to increase pension costs. e) The individual annuity purchase basis is probably not an appropriate basis if the actuarial basis used to calculate transfer values should also be appropriate for converting members account balances (say, under a flexible pension plan) to fixed pensions. That is, the individual annuity purchase basis would probably create unintended profits for the pension plan if such a basis is used to convert account balances into pensions. Alternate Principle 2: Commuted Values Based On Large Group Annuity Purchase Rates The underlying principle for transfer values could be the estimated cost of annuities under a large group annuity purchase basis. Deferred annuities are available under large group annuity purchases, and there would be no particular problems with offering lump-sum amounts at the time of wind-up of a large pension plan. However, very serious problems remain. The true cost of a small block of deferred annuities included in a sale of a large block of immediate annuities is not known. Furthermore, most of the problems associated with the individual annuity basis would continue to apply. The value of indexed annuities would remain uncertain, the employer s cost would be increased by portability, and the basis would still generate profits for the pension plan if used to convert account balances into pensions. Furthermore, the large group annuity principle would eliminate the main attraction of the individual annuity purchase basis, namely the individual s ability to reproduce the deferred pension by purchasing an annuity with the transfer value. 3

5 Alternate Principle 3: Commuted Values on the Employer Cost Basis The principle used to determine transfer values could be the estimated cost or reserve required for the employer to provide the pension. This principle would have a major advantage in that pension portability would be cost neutral for the employer, as pension portability legislation was meant to be. However, the employer cost principle also involves some serious disadvantages, as follows: a) The commuted value of the member s pension would be less than the value of the pension payable from the plan, since the applicable discount rate (a weighted average of stock and bond yields) would likely exceed the discount applicable to a bond such as a provincial or corporate bond. In other words, the member would need to invest in investments riskier than bonds to achieve the rate of return which the pension fund has been generating. b) The employer cost basis would vary from one pension plan to another. Some employers have significantly different mortality levels than others, and no two employers have exactly the same investment policies and performance. (It might be possible to develop a standardized employer cost basis. However, if this were done, the cost neutrality advantage would be lost for most employers.) c) The individual plan member is unlikely to be able to reproduce the vested pension with the transfer value because of administration costs and loss of diversification opportunities. d) The employer actually has two cost bases which are relevant in different circumstances WKH costs which apply on an ongoing basis based on the returns on fund, and the group annuity purchase basis which becomes the employer s cost basis in the event of plan wind-up. Thus, in theory, there would have to be two transfer value bases RQH DSSOLFDEOH LQ WKH RQJRLQJ situation and the other applicable on plan wind-up. Alternate Principle 4: Commuted Values on Market-Related Economic Value Under this principle, the transfer value available to a member would be the economic value the marketplace would attribute to such an annuity in an active open market, without direct reference to benchmarks such as annuity purchase prices or the employer s cost. As previously noted in the section on Risk Considerations, a deferred pension payable from a pension plan may involve a risk somewhere between that of a provincial bond and a corporate bond. Accordingly, it would be expected that the market-related economic value of a pension would be somewhat similar to the value of a provincial or corporate bond with the same stream of disbursements. The main advantages of this approach are as follows: a) Transfer values would be consistent with the price of stripped bonds and other products which have future streams of payments similar to annuities. The main disadvantages of this approach are as follows: b) The underlying principle is more difficult to enunciate and more difficult to explain to plan members than an annuity purchase principle. c) The employer s cost of providing transfer values would be higher than the cost of providing deferred pensions payable from the plan, depending on the degree to which equity returns exceed fixed income returns over the long term. 4

6 Alternative Principle 5: Commuted Values Based on the Amount Needed by the Member to Reproduce his Pension Under this principle, the commuted value would be determined as the amount which the plan member would need to invest in order to reproduce his pension. There are two serious problems with this approach. a) By itself, this principle provides little direct assistance in determining the amount of the commuted value. Instead, it leads to the next question of what classes of investments the plan member would use, since the amount needed by the member depends on the expected return on the class(es) of assets selected by the member. b) The risk characteristics of the member s pension are likely to be changed, giving the plan member a higher or lower value than the value of his original pension: i) If we interpreted the principle to be based on the amount needed by the member based on the investment in the least risky asset class, the transfer value would be relatively high based on the expected returns on treasury bills or other very low risk investments. The use of such a transfer value and related investments would result in a pension with a higher value (based on lower risk) than the value of the original pension payable from the plan. ii) If we interpreted the principle to be based on the amount needed by some combination of assets classes, including equities, the transfer value would be relatively low. The use of such a transfer value and related investments would result in an individual pension with a lower value (based on higher risk) than the value of the pension from the original plan. Despite the theoretical shortcomings of Principle 5, it offers the substantial advantage that it is easily described and acceptable to various parties. Furthermore, we can observe that if the plan member wished to leave the risk characteristics of his pension unaffected, he could invest in bonds such as provincial or corporate bonds. In this case, Principle 5 would lead to the same conclusion as Principle 4. Proposed Conclusion Regarding Underlying Economic Principles The bases described above involve substantial differences. For example, individual annuity prices in the past year have been 5%-10% higher than large group annuity prices, and large group annuity prices are very substantially higher than the employer s cost. 3 Thus, it will not be possible to simultaneously achieve all of the potential advantages of all of the bases. Accordingly, we must choose one particular philosophy or basis, and live with the associated advantages and disadvantages. The CIA task force proposes determining the commuted values on the market-related economic value, as described in Alternate Principle 4. More specifically, to the extent permitted by practical considerations, the discount rate for valuing a stream of pension payments would be similar to the rates applicable to provincial bonds or the safest corporate bonds. Some of the major consequences of this approach will be: a) the value of members lump-sum option will be the same as the value of the deferred pension payable from the plan (based on the risk considerations described in this paper); b) by using an underlying principle other than annuity purchase rates, plan sponsors, pension regulators, and financial advisors will develop an understanding that the transfer value does not represent individual annuity prices, and plan members will eventually become better informed about their options; 3 Some survey results published in the CIA Bulletin, December, 1997 indicate large group annuity prices during 1997 were based on a discount rate which very closely parallels Government of Canada long-term bond yields. 5

7 c) the transfer value received by plan members who leave pension plans before retirement will be more consistent with common current practices (i.e., invest the transfer value until retirement and buy an annuity then); d) the transfer value basis will be fair if used in reverse to convert defined contribution account balances into fixed pensions; and e) the basis will be fair if applied for spouses involved in pension splitting on marriage breakdown. The task force notes that adoption of a transfer value basis which is does not directly simulate insured annuity prices is consistent with actuarial practices in the United States and the United Kingdom. 4 The task force also notes that those individuals who prefer Alternate Principle 5 (the amount the member needs to invest to reproduce his pension) as the guiding principle can view that as the guiding principle, provided that we assume that the member chooses investments which produce a pension with risk characteristics similar to the pension payable from the original plan. That is, assuming investments in bonds such as provincial bonds and the safest available corporate bonds. Expense Issues It is also necessary to address the issue of expenses such as investment and custodial fees. If the transfer value of a pension is determined by applying a gross interest rate (for example, a prescribed bond yield), the member, in effect, pays the fees. Conversely, if the transfer value is intended to cover the member s future investment and custodial fees, the discount rate or some other factor must be adjusted to produce increased transfer values with expense provisions included. From a philosophical perspective, the task force believes that it would be appropriate for transfer values to cover the base fee levels which the plan would normally incur in the course of providing pensions directly from the plan. The task force believes that the individual plan member should pay any incremental fees associated with investing his own retirement assets. That is, the member can choose to leave his entitlements in the pension plan, where the employer will assume responsibility for the investment decisions and the associated fees. Conversely, if the plan member wishes to take responsibility for the investment decisions, then, presumably, the member should be willing to pay the associated incremental fees. Mortality Levels To be fair and neutral to all parties affected by the transfer value basis, the mortality rates (and associated life expectancies) used in the calculation of the commuted value of a pension should be the best available actuarial estimate of the applicable mortality rates, without inclusion of margins for conservatism. The applicable mortality rates should be those which will apply to the member (or rather, to similar Canadian pension plan members on average) in the future during the member s lifetime. Current actuarial practices regarding the use of mortality rates in pension value calculations are changing. Most values are still being calculated using a static mortality table which reflects expected future mortality levels for an applicable group. However, some values are being calculated using current mortality levels subject to projected future improvements, using so-called generational mortality tables. From a 4 A simplified description of other practices is as follows: x In the U.S.A., the commuted value basis was revised in 1995 to use discount rates based on yields on 30-year treasury bonds. Prior to 1995, their commuted value basis was the prescribed guaranty fund basis, which involved four trenches of select and ultimate interest rates and which modelled settlement prices. x In the U.K., the commuted value basis reflects bond yields for the post-retirement period and estimated stock yields for the period prior to pension commencement. 6

8 philosophical perspective, the method used is not crucial. The key point is that the value calculation, regardless of the specific methodology used, should reflect applicable expected future mortality levels. Implementation Issues It should be recognized that, even if the proposed philosophy is unanimously endorsed by the actuarial profession and other interested parties, there will be significant challenges involved finding practical approaches which are reasonably consistent with the philosophy and which can be readily implemented. Examples of implementation issues are: a) Interest rate yield curves change shape on a daily basis, and are not easily approximated by a single interest rate. Thus, various levels of select and ultimate rates (or different interest assumptions for different periods of time) may be necessary to produce a reasonable approximation of the intended result. b) Any economic indicators used should be published by objective sources and readily available. c) Calculation procedures (such as the use of a generational mortality basis) may be approximated by simpler approaches which produce very similar results. In short, the task force believes that development of an updated set of transfer value recommendations involves two important steps: development of a set of underlying philosophical principles and development of a set of practical procedures and approximations which produce the intended results. The Canadian Institute of Actuaries Task Force on Transfer Values: Maarten Den Heyer Marvin B. Ens (chairperson) Minaz H. Lalani Josephine E. Marks Salim A.H. Shariff Douglas C. Townsend Brian L. Burnell (CIA vice-president responsible for the task force) 7

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