- 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 defined contribution pensions, RRSPs or LIRAs 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 actuary 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.
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.
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.
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.