Manitoba is home to many, many industries that feature pension programs. Education, Finance, Healthcare, Manitoba Hydro, the list goes on and on!
If you contribute to a defined benefit pension through work, you may have noticed an interesting trend: the commuted value of your pension has gone up dramatically year-over-year! What is causing this trend? Why, all-of-a-sudden, is the lump sum value of your pension so much higher?
Defined Benefit Pension Basics
Let’s start at ground level as we answer this question. A Defined Benefit Pension means your employer is guaranteeing a specific retirement income in the future. That income amount is typically a formula, using a combination of a) years of service, b) average salary and c) age at retirement.
Calculating the Commuted Value
To get the lump sum or commuted value of your pension, you need to start at the end and work backwards. The pension provider doesn’t hold a lump sum with your name on it. Instead, they need to figure out what dollar amount would provide you with that guaranteed income using the prevailing interest rate. They start with the income promise and then reverse-engineer the lump sum needed to make it happen.
It (Largely) Boils Down to Interest Rates
When interest rates are high, it takes less lump sum money to create an income. When interest rates are low, as they are today, it takes more cash up front to guarantee an income. Makes sense, right? If you can easily earn a higher interest rate on your principal, you need less principal invested to achieve the same outcome.
Looking closer, the math can be quite tricky on this one (which is why actuaries are paid well). For easy comparison, let’s look at a ‘perpetuity,’ which can be thought of as a never-ending pension. The formula for a perpetuity is simply Income / Interest Rate = Lump Sum.
For example, a $50,000/year perpetuity in a 5% interest rate environment requires $1,000,000 to sustain. The same $50,000/year perpetuity in a 2% interest rate environment requires $2,500,000 to recreate!
What to Do With This Information?
When you look at your pension statement and see a dramatic increase in the commuted value, be aware that it’s likely temporary. If/when interest rates rise again, you’ll see that valuation fall accordingly.
If your retirement plans are to take the pension income, this has no real effect on you. If your retirement plans are to commute the lump sum, now might be a great time to consider doing so!
No one has a crystal ball to pinpoint when interest changes are going to arise. This interest rate environment could go on for months or years. What you can do is be aware of how changes will impact your pension plan and adapt accordingly.
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