Will the New Pension Formula Impact Your Income in Retirement?

Pension plans must use a new method for the calculation of the commuted values as of 1 December 2020.

Plan members who transfer the commuted value (CV) of their Defined Benefit (DB) plan could soon receive reduced payments thanks to an updated formula that will come into effect on 1 December.

Some DB plan members, particularly those approaching the plan’s normal retirement date, may experience a relatively small decrease in their CV. However, those who leave or retire around the age of 40, and do not have many years of service, may see their CV payment reduced by 5% or more, depending on the characteristics of the plan. In a February announcement published by Eckler SA, an actuarial consulting firm, it was estimated that changes to the retirement date assumption in the revised December formula could reduce CV payments for people aged 45 in a DB plan with a normal retirement age of 65 by 4% to 7%.

The new formula was developed by the Actuarial Standards Board of the Canadian Institute of Actuaries after a multi-year review process and is expected to enter into force on 1 August 2020. In April, at the beginning of the closures due to COVID-19, the institute announced that it would postpone the deadline to 1 December 2020. Some plans were permitted to adopt the revised standard early.

The new formula uses a revised assumption for the start of the retirement date and a market-based interest rate calculation that reflects not only Canadian government bond yields but also information on the performance of provincial and corporate bond indices. The impact of these two key revisions on the lives of plan participants depends on the age of the plan participant, the bond indices used to calculate the difference, the economic conditions at the time of calculation, and the terms of the plan, as indicated in the Eckler communication.

For plans without early retirement benefits, the change may only have a minor impact on CVs, but CVs will generally be lower under the new rules for early retirement planning. The more generous the benefits, the greater the reduction.

Members of the DB plan who terminate their employment often have the opportunity to remain in the DB plan and regularly receive pension payments upon retirement, or to transfer the CV from the plan and use it to purchase an annuity, or to take it as a lump sum – where part or all of the amount can be transferred to a locked-in retirement account.

Plan members who have recently requested a quote for the CV of their earned pension, but have chosen not to commute their pension until the new year, may find that their CV has decreased due to changes in interest rates and assumptions.

The decision to take a CV from a DB plan is complicated and very personal. It can be one of the most important financial decisions you make when buying a house. When interest rates are low, as they are now, CVs are high, making the decision to transfer a CV a potentially interesting option. However, the amounts withdrawn must be properly invested to create future retirement income. This is unlikely to be achieved by using GICs or other “guaranteed interest” investments, as they are currently paying less than the rate of inflation.

It would be perfectly normal for your risk tolerance to be lower in retirement than it was at the beginning of your career. A more conservative investment mix will produce a lower rate of return over time, but if you are sufficiently diversified, you should expect a return that regularly exceeds inflation.

In addition, usually only part of the commuted value can be transferred to a locked-in retirement account, while the rest may be subject to immediate taxation. If you do not have sufficient RRSP room to offset part, or most, of this excess, you may have to pay some income tax due to this choice.

Opting for a CV may be suitable for plan members who have at least a “balanced” tolerance of investment risks, who do not have a spouse, who have a shorter life expectancy, who receive a relatively low pension, or who have another DB pension income – whether their own or their spouse’s pension. Taking the commuted value of another pension may allow a couple to diversify between pension income and locked-in RRSP investments.