Pension de-risking through offering lump sums

Increasingly popular in the U.S., is this the right option for employers in Canada?
By Gavin Benjamin
|Canadian HR Reporter|Last Updated: 10/22/2013

In the last few years, a number of employers in the United States have moved to reduce their defined benefit (DB) pension risk by offering former employees the lump sum value of their DB pension.

This means former employees are given the option of receiving a one-time lump sum (in cash or rolled over to another retirement plan) instead of a monthly lifetime pension from the pension plan.

In 2012, Towers Watson advised more than 110 U.S. organizations on lump sum pension payment offerings and implemented 93 lump sum programs covering about 400,000 participants formerly employed by these organizations.

The activity south of the border raises the obvious question of whether lump sum offerings to former employees provide de-risking opportunities for DB pension plan sponsors in Canada.

Legislative considerations

In the U.S., one of the triggers for lump sum activity was a 2006 change to the basis for calculating lump sums under the Pension Protection Act (PPA). Previously, employers had to calculate lump sums using an interest rate based on 30-year treasury bonds, which made lump sums more expensive than funding or accounting liabilities.

Under the PPA rule changes, lump sums are now calculated on a corporate bond basis more closely aligned with the funding and accounting measures of pension obligations. This was phased in, so 2012 was the first year the new basis was fully in effect.

In the past, most U.S. employers believed lump sums could be provided to former employees entitled to a deferred pension (deferred vested members) but not offered to retirees. However, in 2012, perceived regulatory hurdles were overcome and a lump sum program that includes retirees is now a viable option.

In Canada, the interest rates that must be used to calculate lump sums are currently producing values roughly in line with solvency funding liabilities, but the lump sum values are typically more expensive than accounting liabilities. Also, it is generally considered acceptable to offer lump sums to deferred vested members, while offers to retirees would likely not be permitted in many, if not all, jurisdictions.

Many pension plans in the U.S. have accumulated large numbers of deferred vested members, since offering a lump sum at termination of employment has not been a requirement in the U.S. As a result, a program that offers lump sums to these members may result in a meaningful reduction in pension plan obligations.

In Canada, offering a lump sum at termination of employment has been a requirement since the late 1980s for most pension plans, with the result being existing deferred vested members typically represent a smaller proportion of a pension plan’s obligations compared to the U.S.

Why offer lump sums?

In Canada, there are a number of reasons why an employer might consider lump sums:

Reduced risk: The payment of lump sums reduces the size of a pension plan’s obligations, thereby reducing pension risk. Interest rate, longevity and investment risks are transferred to former members who elect for a lump sum. Even if the obligations for deferred vested members are small relative to the obligations of the entire plan, a lump sum offering could be the first step in a larger de-risking journey plan.

In addition, employers keen to reduce pension risk can consider amending the pension plan to offer a lump sum to active employees at the time of their retirement. In all cases, the lump sum options will be subject to applicable pension standards legislation that generally gives eligible members the right to transfer their lump sum to another pension plan or a tax-deferred retirement savings plan (often on a locked-in basis), purchase an annuity or receive a cash payment, depending on the situation. Tax rules respecting maximum transfer values must also be applied.

Reduced costs: The costs and effort associated with the future administration of deferred vested benefits are eliminated for those members who elect a lump sum. Locating the members to start their monthly pension at retirement becomes more difficult as time passes. Also, there are costs associated with preparing a retirement option package, processing elected monthly pension payments and processing a revised pension amount payable to a spouse upon her death. In addition, some jurisdictions require (or will likely require in the future) that inactive members be provided with periodic pension statements.

From an administrative standpoint, it may be particularly attractive to offer lump sums to deferred vested members with small pensions, as the future administrative costs are usually disproportionately high relative to the size of the benefit entitlements. In some jurisdictions, such as Ontario, it is possible to require former employees with pensions below certain thresholds to accept the lump sum value in lieu of monthly payments.

Eliminated fees: Annual regulatory fees are eliminated for deferred vested members who elect a lump sum. For example, annual information return fees for plans registered in Quebec are $9.05 per year for each active, retired and deferred vested member. In addition, depending on the financial position of the pension plan, the Pension Benefits Guarantee Fund (PBGF) assessment fees in Ontario can be significant. For example, if these fees are capped at the dollar-per-member limit, each deferred vested member employed in Ontario could be costing the employer as much as $324 per year in fees.

Changes to mortality assumption: At the end of July, the Canadian Institute of Actuaries (CIA) released a draft report about the Canadian pensioner mortality experience. Once finalized, it will likely lead to changes to the prescribed mortality assumption used to calculate lumps sums. These changes could come into effect as early as March 31, 2014, and preliminary indications are the new assumption could increase lump sum values by five to 10 per cent. Therefore, a window of opportunity exists to implement a lump sum program prior to any changes to the prescribed mortality assumption.

Considerations

Below are some considerations for employers in implementing a program to offer lump sums:

• Since lump sum values increase when interest rates decrease, some employers may question whether it is appropriate to offer lump sums when interest rates are near historical lows. While the rates increased during the first half of 2013, it is difficult to predict when they may increase to the levels they were a few years ago. Also, the take-up rate for a lump sum offering may be higher when interest rates are low (because the lump sum values being offered will be higher).

• A lump sum offering could result in the need to make a special one-time contribution to the pension plan and could trigger special one-time “settlement” accounting treatment.

• Employers that intend to implement a future lump sum program — if interest rates rise or the pension plan becomes better funded — should decide now on the triggers for moving ahead with such a program. Since a window of opportunity (such as a spike in interest rates) may be short, taking preparatory steps will enable the employer to quickly implement a lump sum program when the right opportunity arises.

• Take-up rates for a lump sum program may vary depending on factors such as: the age and service profile of the deferred vested member group; members’ confidence in the long-term viability of the pension plan; to what extent their lump sum value remains eligible for tax-deferral and is subject to pension standards locking-in requirements; interest rate levels; and their desire to invest and manage what may be a significant amount of money.

• In order to reduce litigation risk, an employer should be able to demonstrate that former employees who were offered a lump sum were able to make an informed choice. So it is important the offer be communicated in a clear, unbiased manner.

Employers have a number of available options for managing the costs and risks associated with their pension plans. Ideally, an employer should establish a “journey plan” that outlines in detail the employer’s planned actions and timeline for attaining the appropriate level of pension risk. And there are a number of reasons why offering lump sums to former employees should be considered a potential option to help achieve pension cost and risk-management goals.

Gavin Benjamin is a senior consulting actuary at Towers Watson in Toronto. He can be reached at gavin.benjamin@towerswatson.com or (416) 960-7419. For more information, visit www.towerswatson.com.

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