- How does an actuary determine the value of a defined benefit pension?
- Does the value of a pension have to be adjusted to reflect income tax?
- What are the main issues that I should be aware of for a defined benefit pension valuation?
- Do supplemental pension plans need to be valued by an actuary?
- Do defined contribution pensions and RRSPs need to be valued?
Answers to Frequently Asked Questions
How does an actuary determine the value of a defined benefit pension?
An actuary determines the value of defined benefit pension benefits, or the capitalized value of defined benefit pension benefits, using the actuarial present value method. Under this method, the capitalized value of the pension benefits is determined as the amount that would need to be invested at the valuation date in order to provide either a monthly pension commencing on a future assumed retirement date, or in the event of death prior to retirement, a lump sum death benefit. The monthly retirement pension is assumed to be payable for the lifetime of the member. Each future payment is discounted with interest to the valuation date and adjusted to reflect the probability that the member survives to receive payment. For example, the present value of each pension payment in retirement is adjusted to reflect the probability that the member lives to receive payment.
Basically, the capitalized value of the member’s pension benefits represents the amount of money that they would require in an RRSP to provide the same amount of pension commencing at their assumed retirement date for their expected lifetime.
The interest rate assumptions (which are based on government bond yields) and mortality rate assumptions that are used by the actuary are specified by the standards of practice of the Canadian Institute of Actuaries.
In many cases the value of a pension needs to be adjusted to reflect the income tax that will paid when the pension is received as income. The only situation where an income tax adjustment is not necessary is when tax deferred assets are equalized (each spouse ends up with half of the total pension assets and these assets are not traded against other assets) and both spouses are projected to have similar retirement income; in this case the equalization of the pension assets can be done on a pre-tax basis.
Prior to retirement, income tax has not been paid on the funds in an employer pension plan or the funds in an RRSP. The contributions made to these registered pension plans were tax deductible and the investment income earned has not been taxed. As a result, income tax will be paid on any payments the person receives from these plans. So $100,000 in an RRSP (or a $100,000 defined benefit pension) is not equal to $100,000 in a chequing account because the person will have to pay income tax on the $100,000 from their RRSP (so the $100,000 in their RRSP is worth less). In order to compare the value of pensions to other assets, they must be reduced to reflect the anticipated income tax that will be paid in the future. This reduction to the value of the pension is also referred to as an income tax liability or contingent income taxes.
Even in the situation where a couple equalizes the pension assets, in some cases income tax calculations would need to be performed to ensure that both spouses end up with the same after-tax amount of pension assets. This is because a pre-tax asset is worth more to the spouse with lower income (in the lower tax bracket). For example, suppose a couple had earned $100,000 in RRSPs during marriage and one spouse is projected to have significant employment income in retirement (and not the other spouse). Suppose that they decide to equalize the $100,000 in their RRSPs by each taking $50,000. In retirement, the spouse with the employment income will be in a much higher tax bracket and will receive much lower after-tax payments from the $50,000 in their RRSP compared to the spouse with no employment income in retirement. To equalize the after-tax value of the RRSPs, a larger amount would need to be transferred to the spouse in the higher income-tax bracket.
In the previous situation, however, it is advantageous for the couple to transfer RRSP assets to the spouse without the employment income as they will pay much less tax on withdrawals from the RRSP which will effectively increase the after-tax value of the family assets. In general, a separating couple can increase the after-tax value of their family assets by transferring all tax-deferred assets (i.e. RRSPs) to the spouse with the lowest regular income and in exchange, transfer after-tax assets to the spouse with the highest regular income. In addition, this often this makes sense from a financial planning perspective since the spouse with the low income will be provided with assets that can be used as income.
In accordance with Canadian actuarial standards, when an performs a defined benefit pension valuation, they will estimate the effect of income tax on the pension. This will depend on the member’s assumed retirement income. The more income they are expected to earn, the higher their assumed tax rate, which will result in a lower after tax value of their pension. For other retirement assets such as RRSPs, an income tax calculation would need to be performed to determine a fair adjustment. We can determine the correct income tax adjustment for all retirement assets.
What are the main issues that I should be aware of for a defined benefit pension valuation?
The single most disputed issue in the pension valuation of a defined benefit pension is the retirement age assumption for people who have not yet retired. Usually this assumption ranges from the earliest date at which the member will be able to retire with an unreduced pension to the normal retirement date of the plan (often age 65). The earlier that a member is assumed to retire, the more valuable their pension. Depending on the situation, assuming the earliest possible date can increase the value of the pension by 30% or more.
From an actuarial perspective, the correct date would be the member’s most likely retirement date. However, as one might expect, this is often heavily disputed. If an assumed retirement date has not been agreed upon by both spouses, as is usually the case, an actuary will provide the value at various assumed retirement dates, in accordance with Canadian actuarial standards.
In addition, there are different valuation methodologies with respect to the treatment of post-valuation increases in the pension: the monthly amount of pension can be calculated by ignoring future increases in the pension such as future earnings increases (typically referred to as the termination method) or the member’s pension can be projected to retirement including future salary increases which results in a higher value for the pension (typically referred to as the retirement method). Under the termination method, the member is not necessarily assumed to have literally terminated their membership in the plan; although the amount of pension is calculated assuming termination, for the purpose of determining the retirement date the member can be assumed to continue their membership and take advantage of the early retirement benefits under the plan. The choice of methodology is ultimately a question of law.
Another issue to consider is the effect of income tax at retirement. For more details on the income tax adjustment, see the question ‘Does the value of my pension have to be adjusted to reflect income tax?’ above.
The Income Tax Act limits that amount of pension that can be paid from a registered pension plan and supplemental pension plans generally pay any pension in excess of these limits. Supplemental plans are generally either available to every member of a pension plan whose pension exceeds income tax limits or the supplemental plan is restricted to a certain class of employee (i.e. executives). Generally speaking, a member’s earnings have to be fairly high in order to have benefits in a supplemental pension plan (i.e. $125,000 or higher). Supplemental pension plans can be either a defined benefit pension plan or a defined contribution pension plan. Defined contribution pension plans are fairly simple to address as they are just investment accounts. Supplemental defined benefit pension plans are more complex and are more difficult to divide on divorce.
Supplemental defined benefit pensions can either be divided using an ‘if and when’ approach or the member spouse can buy-out the non-member spouse. The choice between these two options is a legal issue and not an actuarial issue; an ‘if and when’ arrangement may be required if there aren’t sufficient assets to offset the value of the supplemental pension. Note that for federal civil servants, any supplemental pension benefits are automatically included in the maximum transfer value paid from the Pension Benefits Division Act, click here for more information on the Pension Benefits Division Act. Under the ‘if and when’ approach, the non-member spouse would receive their portion of the supplemental pension when it becomes payable; the ‘if and when’ approach can be problematic since pension plan administrators may not agree to pay the non-member spouse directly so the member will have to provide the non-member spouse with a regular pension payment and there will not be a clean break for the couple. In addition, there are other complex issues which need to be addressed, such as the treatment of any pre-retirement death benefits. The big advantage to having the member spouse buy out the non-member spouse is simplicity and to have a clean break between the couple; the disadvantage to a buy-out is that the supplemental pension will need to be valued by an actuary and the couple will need to have sufficient assets to trade against the pension.
The pension plan administrator will not typically provide a value for a member’s supplemental pension benefits as these benefits are often unfunded and unavailable to members who terminate from the pension plan prior to retirement. Since these plans are in excess of income tax limits, they are not governed by pension benefits legislation and the plan administrator has no legislated obligation to provide information about these plans. In addition, these benefits are often overlooked by divorcing couples as the value of the registered pension benefits is assumed to include the value of all of a member’s pension benefits. If either spouse is a high earner and a member of a defined benefit pension plan, it is advisable to investigate the possibility of supplemental benefits.
Do defined contribution pensions and RRSP’s need to be valued?
RRSPs and defined contribution pension plans do not need to be valued. This is because, unlike with a defined benefit pension plan, defined contribution pension plans and RRSPs are simply tax deferred investment accounts and so the value at any point in time is equal to the account balance. For this reason, a valuation is not necessary to determine the pre-tax value for these assets.
However, in many cases, it is necessary to determine an income tax adjustment (income tax liability) for defined contribution pensions and RRSPs. Often the income tax adjustment is set arbitrarily, resulting in after-tax values that overstate or understate the fair value by thousands of dollars. In addition, some of the funds in an RRSP or defined contribution plan may have originated from a defined benefit pension plan, which will require a more careful analysis. For more information on RRSPs on divorce, click here.
If you have any additional questions, or require clarification, please do not hesitate to contact us.