Due to the recent increase in interest rates, the financial world has felt ripples across all sectors. It’s not just the average Joe who is struggling to pay their mortgage or the stock market is in crisis. We have also seen change converted value of pensions in a defined benefit planand is attracting attention in the retirement industry.
Defined benefit plans, once the norm, have become something of a golden goose in the corporate world. They promise retirees a set amount each month, a seemingly immovable pillar of security in their twilight years. However, as interest rates rose, the basis for these plans began to change. Converted value – basically what you would get if you decided to immediately take your money and run – is a rollercoaster ride.
How interest rates affect the value of your pension
- If interest rates are tall, the present value (or converted value) of the future cash flow decreases. This is because with high interest rates, less money is needed today to generate a given amount in the future. In the case of pensions, this means that the plan would now need less money to cover future pension payments. Think of a rocker: rates up, commutated value down.
- And vice versa if interest rates are Short, you need a larger amount of money today to ensure the same amount in the future. This increases the value of the pension. Since 2020, we have observed a decrease in the amount of commuting by 200,000. USD.
Bond interest rates and inflation
Interest rates are rising because investors expect inflation. When inflation is expected to increase, investors require higher interest rates to compensate for the decline in the purchasing power of money over time. Rising interest rates mean bond yields rise, which costs borrowers but benefits bond investors. Remember that interest rates are inflation + risk premium + profit. The short answer: interest rates drive inflation.
Discovering Commutated Value and Rising Interest Rates
So let’s get down to the basics. Your Commutated value (or CV for the cool kids) is basically the present value of all the future retirement benefits you are expected to receive. This is essentially the “present value” of your future retirement benefits. This calculation, rooted in the Pension Benefits Act, relies largely on assessments of the present value of expected future pension payments.
Your modified pension value is a treasure chest. That’s how much experts – actuaries – believe your pension is worth in today’s dollars. And oh boy, can it shine bright! A decent defined benefit pension boasts a converted value of $250,000 to $1,000,000 or more. That’s a lot of zeros!
The converted value of your defined benefit pension is synchronized with Canadian government bond yields and changes daily. A fall in interest rates inflates the value of the pension, while a rise has the opposite effect. Basically, with rising interest rates, you need to put down less today to achieve a given future monthly income.
To break it down:
- At an interest rate of 1%, a year-end payment of $10,000 would have a converted value of $9,900.99 today (1/1.01*10,000).
- At a rate of 5%, today’s converted value of the same payment would drop to $9,523.90 (1/1.05*10,000).
For retirees considering commuting to retirement, this change is significant. Especially when extrapolated to a 30-year retirement life expectancy, your value could potentially drop by hundreds of thousands of dollars!
Actuaries: The Whiz Kids behind the scenes
Have you ever heard of actuaries? They are mathematical wizards who analyze financial risk, especially when it comes to pensions. When analyzing these numbers, they follow a framework developed by the Canadian Institute of Actuaries.
Calculating the commutated value
How do they actually calculate commuter value? Present value is calculated as PV = FV / (1 + i)^n, where present value equals future value divided by one plus expected interest rate for “n” number of years.
Without getting lost in the mud, this formula translates into today’s value of future pension payments. But the thing is simple – although this formula is standard, companies may have their own unique character, which complicates the CV. At Pension Solutions Canada.com we cannot calculate your CV. This can only be done by your retirement plan’s actuary. But we will help you understand and develop a strategy.
Types of retirement plans and resumes
Defined benefit vs. defined contribution plans: The commutation value calculation is specific to defined benefit pensions. Under these plans, you are assured of a fixed pension amount when you retire. Conversely, in defined contribution plans, your pension benefits are uncertain and depend only on the performance of the investments in which your contributions are invested.
Understanding your resume on your retirement statement
Retirement is approaching, or maybe you’re changing career gear. Either way, a retirement statement that includes your character on your CV is crucial. Given that huge sums of money are often at stake, it is important to strategize wisely.
Will my CV be enough for a comfortable Canadian retirement? There are many variables at play – your health, where you want to nest and the type of lifestyle you lead. Remember, however, that you decide on your expenses. With the right strategy, you can make your retirement dreams come true.
Check out our other blog articles on how much you need to retire comfortably in Canada.
Cash on CV: How to play it
So the important moment comes and you want to “cash out” your CV or “take a lump sum”, you have a choice:
- Put it in a blocked retirement account (LIRA): Most of your CV can go here, but anything above the set limit becomes taxable cash.
- Boost your Registered Retirement Savings Account (RRSP): If there’s room, put that taxable cash into an RRSP. If not, it’s time to talk about taxes.
- Take advantage of an annuity (also known as a follower annuity): Imagine an annual fixed income that reflects your retirement benefits. This is the magic of annuities. In other words, collect your lifetime pension from Sun Life or Canada Life, not your company.
Tax implications: The elephant in the room
The huge amount of value exchanged can be misleading. A difficult question arises (pun intended!) – how much of this amount actually ends up in your bank account?
Come in Maximum transfer value (MTV). This is a calculation that determines the portion of the converted value that can be safely placed in tax-advantaged accounts such as LIRA or LIF.
This value is influenced by your annual pension benefits and age. And while MTV keeps the taxpayer at bay, anything over that amount will be taxed based on your income bracket.
In the world of high commuting values, it is not unusual for 10% – 25% to be taxed at an individual rate. For larger amounts, this could push you into a higher bracket, meaning even more taxes. Ouch!
However, there is a ray of hope! If you have room in your RRSP, you can shield some of it from the tax storm. We saw people with a spare room of PLN 180,000. dollars in RRSP. Please note that some employers allow direct rollovers to your RRSP, others do not.
Do you have a CV quote? Call the professionals!
When a golden envelope (or, more likely, an email) arrives from HR containing an estimated resume, it’s wise to get a second opinion. Trusted certified financial planners can be a lifesaver here. Here on Canada.com retirement solutions, we offer a free consultation call to assess the value of a commuting pension and explore your options, giving you a complete picture.
click here to book a virtual consultation call.
