In a nutshell

The bottom line is that for Ontario Nortel pensioners only, CV is calculated (as defined in the legislation and the same as for deferred pension plan beneficiaries) on windup date life expectancy and some of the CV is considered to have already been collected since windup, so it’s worth less now. Whereas the annuity is locked in based on the funded status of the pension plan on windup date and guaranteed at that level by PBGF (no upside or downside to pensioners). For those who are alive after windup, CV/LIF value and cost to buy annuity diverges.

Background

In 2014 Nortel pensioners (and those entitled to deferred pension benefits) will have an important decision to make, whether to take an annuity approximately equal to their current reduced pension or its Commuted Value (CV) to be transferred into a LIF. Typically the dollar value is the same, irrespective of the choice, and that will be the case for non-Ontario pensioners in Canada.  But that will not be the case for Nortel’s Ontario pensioners. (You can read more about LIFs in my LIF- What is it and why important for Nortel pensioners  blog. I have also tried to generate in the Annuity or Lump-Sum (LIF): Upcoming Nortel pensioners’  decision an objective discussion of the pros, cons and other qualitative considerations that go into this very personal decision. For those who will be leaning towards a CV/LIF choice, there will be another hurdle which is to convince themselves that for the portfolio returns they are likely to get in the LIF whether they have a reasonable chance of beating the annuity, especially in light of the lower CV/LIF value. But that’s another topic.)

Typically those who are already collecting pensions do not have the option to elect CV. But special Ontario legislation was passed, driven by NRPC advocacy, allowing CV option for Nortel pensioners. However a recent wrinkle to this decision has emerged in a Nortel pensioners’ NRPC presentation which indicated that CV/LIF value will lower than the annuity value for Ontario Nortel pensioners.

Numerous pensioners approached me to try to explain the reason for this apparent penalty on those wanting to choose CV/LIF option. I was just as puzzled as they were.

I approached Morneau Shepell, the Nortel pension administrators appointed by the Ontario government after the bankruptcy, and they explained to me the reasons for the difference as follows (Thanks to Ms. Seewald and Mr. Dunlop of M-S for the explanation; I’ll take responsibility for any misunderstandings or errors).

The explanation

Q: So why is LIF/CV value not the same as (but probably lower than) than the annuity purchase value?

A: The answer is all in the Ontario pension legislation Ontario Regulation 10/13 under the Pension Benefit Act; specifically Section 8 of this Regulation

So as per the Ontario legislation the procedures are as follows:

-everything is calculated effective official windup date of Oct. 1, 2010

-pension plan funded status was calculated as of windup date using conservative assumptions for purposes of interim cutbacks implemented in August 2011

-Ontario pensioners are now receiving the current reduced pension based on that funded status

-pension plan assets were fully immunized, i.e. they are essentially were rendered largely insensitive to interest rate changes since windup date

-(however, the conservatism built into the current funded status might allow a small increase when annuity purchased, when all the plan data is finally fully  verified)

-CV/LIF is calculated as per Ontario legislation and is based on interest rates on windup date (3.1%)

-the annuities to be purchased will cost more or less than windup date scenario, but the PBGF protects downside of annuity cost relative to windup assumptions (but keeps any upside should it occur)

So why is CV/LIF value likely lower than the cost of annuity to be purchased? This is because:

– CV is calculated using exactly the same methodology as for deferred vested members

-because the CV is calculated effective Oct 1, 2010 windup date and Ontario legislation requires that the CV/LIF payment to be: the CV value on windup date (and life expectancy on that date), plus interest on CV since then, minus payments received since windup date

However note that, for example if 5 years have elapsed since then and for a 90 year old individual’s life expectancy was 5 years:

-but the 90 year old is now 95 and still might have a 2-3 year life expectancy, and would get an annuity to cover that life expectancy,

-but CV would be worth much less that annuity as CV was based on 5 year life expectancy 5 years ago at windup so pensioner is already deemed to have effectively collected most of the CV

– younger ages would be similarly affected but  to a lesser extent

– (The UP94 (projected to 2020) mortality table will be used.  This was the table contained in the CIA Standards of Practice referred to in S. 8 that were in effect on June 3, 2010. The Canadian Institute of Actuaries has updated the mortality table recently.)

Note that the above discussion excludes an upside that may result from recoveries from the ongoing bankruptcy proceedings.

Bottom line:

The bottom line is that CV is calculated (as defined in the legislation) on windup date life expectancy and some of the CV is considered to have already been collected since windup, so it’s worth less now. Whereas the annuity is locked in based on the funded status of the pension plan on windup date and guaranteed at that level by PBGF (no upside or downside to pensioners). For those who are alive after windup, CV/LIF value and cost to buy annuity diverges.

P.S. Pensions are some of the most complex financial products invented by man and far be it for me to claim that I am an expert in the field , but something doesn’t feel right. Does it not feel like CV/LIF takers are getting increasingly short changed as we move further and further from the deemed (but not executed) windup date.

P.P.S. A further update to the above was provided in Hot Off the Web- December 23, 2013

“And speaking of the Nortel pension, a few weeks ago in my “Nortel pensions: Why CV/LIF value is less than annuity value for Nortel’s Ontario pensioners?”  I discussed the recent revelation that while the Ontario government did make an exception for the Nortel pensioners to allow not just deferred pensioners but also those already collecting pensions the option of taking Commuted Value (CV) rather than an annuity. This option was to be available to be exercised when the 40% underfunded plan will be wound up perhaps late in 2014, however it came with a little caveat. The caveat is that the CV will be calculated as explained in that blog in the same way as the CV for deferred pensioners. The result is that pensioners who might be considering taking CV will have to accept a penalty which might make the CV unpalatable for the vast majority of pensioners. Specifically, the penalty is estimated to be from a minimally decision impacting 2-4% for pensioners who were 60 when the theoretical windup occurred in October 1, 2010, to the order of almost 50% for those who were 85 years old at the time. The Ontario government’s legislated CV formula might have made sense if the time between the theoretical windup and the CV decision was perhaps 60-days or so as it might typically be. However the legislated formula gives no credit for the mortality that will have occurred over the four years since October 2010. So those choosing CV will get less than their fair share (in addition to having missed the last 4 years of stock market rebound as they were not in control of their share of pension plan assets).”