How commuted-value calculation changes will impact lump-sum DB pension payments
In January 2020, the Canadian Institute of Actuaries released final changes to the actuarial standards of practice for calculating commuted values, with the changes scheduled to come into effect on Dec. 1, 2020.
The changes will affect the lump-sum amounts paid from many Canadian defined benefit pension plans in situations such as: the termination of employment of a plan member; the retirement of a member where the plan permits portability at retirement; the pre-retirement death of a member; and in the case of a plan windup.
For traditional DB plans, the most significant changes to the commuted-value standards of practice are the modifications to the following assumptions used to calculate commuted values: the interest rate assumption and the pension commencement age assumption.
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This article focuses on the modifications to the interest rate assumption. Note that the changes to the commuted-values standards for certain multi-employer and target pension plans differ from those described above and aren’t addressed here. Also, the changes to the commuted-values standards don’t affect amounts paid from defined contribution pension plans.
Current standards of practice
A commuted value represents the lump sum present value of the estimated monthly lifetime pension payments a former plan member was entitled to receive from their plan. In order to calculate the present value, an interest rate assumption is required to discount the estimated future payments back to the commuted-value calculation date.
This interest rate assumption varies monthly and is made up of two interest rates. The first rate applies for the first 10 years after the commuted-value calculation date and the second rate applies to the period beyond 10 years.
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Under the current standards, the monthly interest rates are first determined using Government of Canada bond yields and then a fixed 0.9 per cent per year “spread adjustment” is added. For example, in the case of a DB plan member who terminated employment in October 2020, the commuted-value interest rates based on government bond yields alone would be 0.4 per cent per year for the first 10 years and 1.5 per cent per year thereafter. Once the 0.9 per cent per year spread adjustment is added to these rates, the final interest rates become 1.3 per cent per year for the first 10 years and 2.4 per cent per year thereafter.
New standards of practice
The new standards use a more market-based approach to determine the commuted-value interest rate assumption. The 0.9 per cent per year fixed spread adjustment will be replaced by spread adjustments that will vary monthly based on the spreads on the yields of provincial and corporate bonds over government bond yields.
More specifically, the yield adjustments will be determined as two-thirds of the yield spread of provincial bonds and one-third of the yield spread of corporate bonds. The spread adjustment will be capped at 1.5 per cent per year and can’t be less than zero.
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Returning to our example, if the new standards had already been in effect, the spread adjustments for the month of October 2020 would have been 0.9 per cent per year for the first 10 years and 1.3 per cent per year thereafter. Once these spread adjustments are added to the interest rates based on government bond yields alone, as described above, the final interest rates would have been 1.3 per cent per year for the first 10 years and 2.8 per cent per year thereafter.
Note that the October 2020 interest rate for the first 10 years under the new standards would have been the same as under the current standards, while the interest rate after 10 years would have been 0.4 per cent per year higher under the new standards.
Effect of change in interest rate assumption
The effect of the change in the interest rate assumption will depend on bond yields and will vary over time. The following chart shows the difference between the interest rates under the new standards and the rates under the current standards for non-indexed pensions for the months of January through October 2020.
The following are a few observations regarding the change to the interest rate assumption:
During recent years, the interest rates under the new standards would generally have been higher than the rates under the current standards. This would have decreased commuted-value amounts compared to the current standards. However, there have been periods in the past during which the new standards would have produced lower interest rates, thereby resulting in larger commuted values.
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In early 2020, the differences between the interest rates under the new and current commuted-value standards were small. For example, in January and February, the interest rate for the first 10 years was 0.1 per cent per year lower under the new standards and the rate for the period beyond 10 years was 0.2 per cent per year higher.
When the financial market volatility due to the coronavirus pandemic began in March, the spread of the yields of provincial and corporate bonds over government bond yields increased significantly. This resulted in a significant difference between the interest rates under the new and current standards, with this difference beginning to emerge in April since the interest rates are based on bond yields from the previous month end.
For example, yield spreads increased so much in March that the spread adjustments under the new standards were capped at 1.5 per cent per year in April (0.6 per cent above the fixed 0.9 per cent spread adjustment under the current standards). Recent months have seen a reduction in the divergence between the interest rates under the new and current standards compared to the difference that occurred at the height of the market volatility.
A frequently asked question is whether the interest rates under the new standards will be more volatile, because the spread adjustments will vary month-to-month instead of being fixed. While it’s impossible to predict the future, a case can be made that the interest rates may be less volatile over the long term. Interest rates under the current standards already vary monthly due to changes in government bond yields.
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Under the new standards, the monthly variations in interest rates will depend on changes in both government bond yields and provincial and corporate spreads. As was the case during the market volatility earlier this year, there’s a tendency for provincial and corporate spreads to increase when Government of Canada yields decrease and to decrease when government yields increase. This effect may cause a dampening of the volatility in the interest rate assumption over time.
When the changes to the commuted-value standards of practice take effect later this year, one of the key changes is a move to a more market-based approach for establishing the interest rate assumption. In the short term, this change will likely increase the interest rates used to calculate commuted values, which will reduce commuted-value amounts.
The effects of the change over the mid and long terms remain to be seen. Also, keep in mind that the change to the pension commencement age assumption, which in some cases will reduce commuted-value amounts, hasn’t been addressed in this article.