Deferred vested members (fully vested members who delay commencing their pension until retirement) have always been a headache for defined benefit pension plan sponsors. Defined contribution pension plan sponsors are fortunate not have to deal with this issue – members simply elect to transfer their account balance when they terminate employment and are off the books. Not only are deferred members costly for defined benefit sponsor to keep on the books, the price tag could soon go up.
In Ontario legislation requires plan sponsors to allow 90 days for members to transfer their pension as a lump sum; however, many plan sponsors are offering members the option of transferring their pension far beyond that – right up to retirement in some cases.
With Ontario recently increasing the small benefit threshold for annual pensions to 4 per cent from 2 per cent of the YMPE (Year's Maximum Pensionable Earnings), it’s become even easier to force members (who are often more costly to keep on the books) to accept lump sum payouts. Here are some good reasons why you should consider extending the window members have to transfer their commuted value.
It can be difficult and costly to locate deferred members, some of whom left the plan more than a decade ago. The National Search Unit of Human Resources and Social Development and private firms will lend a helping hand – at a cost. Once you locate the member, you’ll need to provide an updated pension package, your plan custodian will need set up the pension, and payout any further benefits payable to the surviving spouse, beneficiaries or estate, when the member passes away.
Ontario is mulling the idea of mandatory inactive statements, which would add yet another expense for plan sponsors already struggling to keep their pension plan fully funded in the current low interest rate environment.
If you’re a defined benefit plan sponsor with a large portion of your membership in Ontario, you’re required to pay premiums to the Pension Benefits Guarantee Fund (PBGF) to guarantee their accrued pension in the event of plan insolvency – that includes deferred members. Fees more than quadrupled when the PBGF raised the base fee from $1.00 to $5.00 effective January 1, 2012. In fact, if your pension plan is severely underfunded, you could be paying upwards of $324 per deferred member annually.
The good news is all these costs are eliminated when members elect to receive their pension as a lump sum. Deferred members who leave prior to the retirement age who decide to start their pension early are often offered less generous retirement reductions than active members, which is one of the many advantages for former employees to commute their pension.
De-risking has always been a priority for plan sponsors. The desire to de-risk was further exacerbated by the financial crisis of 2008, which left many pension plans underfunded – plan sponsors are still trying to recover five years later. When members receive a lump sum payout, not only are the pension plan’s obligations reduced, many of the risks inherent in offering a defined benefit plan – interest rate risk, investment risk, and longevity risk – are shifted to former members.
By allowing deferred members to remain in the plan, they pose an open liability for plan sponsors. Deferred members who are eligible for retirement can decide at any time to commence their pension. Plan sponsors have gone as far as offering lump sum payouts in retirement, although it may not be beneficial to the employee, who may be forced to receive a large portion of their payout in cash subject to ITA (Income Tax Act) limits in effect, taxed at their marginal tax rate.
Changes in Mortality Assumptions Coming Soon
The Canadian Institute of Actuaries has indicated a long overdue change to the mortality assumptions of defined benefit plans is likely coming in 2014. These revised assumptions will better reflect the fact that pensioners are living longer than ever, as life expectancy continues to climb with each passing year. Although only in the preliminary stages, it’s speculated that these changes could increase the commuted value by as much as 10 per cent.
If you’re thinking of encouraging members to take a lump sum payment, there’s never been a better time, as it could get a lot more costly once these changes take effect.