1.0 Actuarial / Pension Matters
 
 
Confusion Created in Pension Valuation for Family Breakdown Case Law by the Use of the Expressions "Termination Method" and "Retirement Method" By Jack Patterson, , F.S.A., F.C.I.A
 
 
 

Reprinted from Family Law Quarterly, October, 1998, with the kind permission of Carswell, a division of Thomson Canada Limited

CONTENTS Top of the Page


1. Problems With Recognition Of Future Productivity In Excess Of Inflation
2. Calcualtions Of Present Values Of Pensions Usually Accurately Reflect Inflation
3. Public Sector Pension Plans (Fovernment Employees and Teachers)
4. Hilderley v. Hilderley
5. Public Sector Case Law Is Inappropriate For Private Sector Plans
6. Private Sector Pension Plans
7. Employer contributions To The Asses Of Final Average Plans Reflect Pre-Retirement Indexing
8. Ontario Case Law On Private Sector Plans

1. Problems With Recognition of Future Productivity in Excess of Inflation Top of the Page

The use of the expressions "Retirement Method" and "Termination Method" has created much confusion in case law on pension valuations for family law. The expression "Retirement Method" has been used to represent at least three entirely different concepts. Until these terms are finally abandoned and replaced by more specific expressions, case law will continue to be vague and appear to be inconsistent from case to case.

The use of the expressions "Retirement Method" and "Termination Method" has created much confusion in case law on pension valuations for family law. The expression "Retirement Method" has been used to represent at least three entirely different concepts. Until these terms are finally abandoned and replaced by more specific expressions, case law will continue to be vague and appear to be inconsistent from case to case.

When actuaries are working for a pension plan calculating employer contributions, it is considered to be good practice to recognize that salaries increase over time to recognize these two factors:

  • Salaries increase to reflect increases in the Consumer Price Index and the decreasing purchasing value of the dollar, and
  • Salaries also increase to reflect promotions and other evidences of future productivity over and above inflation.

If either of these features is not recognized, the pension plan is likely to become seriously underfunded.

When equalization of family assets was first introduced in Ontario, some early actuarial reports continued to use estimates of future salary increases which combined both factors. The Standard of Practice of the Canadian Institute of Actuaries defines the term "Retirement Method" to include estimates of such salary increases.

The Ontario courts immediately and consistently rejected this particular "Retirement Method" (1) for the following reasons:

  • it involved speculative unsupported future estimates of the effect of future promotions and other evidences of productivity of the plan participant after the valuation date over and above the effects of inflation;
  • in some cases the salary of the plan participant in the year of the trial was actually lower than the estimate the actuary had made earlier on the date of valuation (the method was obviously inaccurate); and
  • it is not the intention of the Family Law Act (2)to consider future productivity after the valuation date. Even in the case of a participant in the Canadian Forces Superannuation, with a history of rapid promotions, any attempt to recognize promotions after the valuation date would be rejected.

Since this particular "Retirement Method" was so clearly inappropriate, a vague expression "Termination Method" emerged to represent the alternative of not reflecting future productivity in excess of inflation.

What this term really implies is that, in the case of final average salary plans, the pension to be valued should be based on the average salary for a period ending at the valuation date, as if employment had terminated at the valuation date, reflecting no speculative allowances for future promotions and other productivity.

It would have been far better to have been more specific and to have created terms that more clearly expressed the problems the courts were trying to avoid. The terms "recognition of future productivity" and "no recognition of future productivity" express more precisely the specific issues which the courts were addressing.

Another vague use of the terms "Termination Method" and "Retirement Method" could be replaced by the more precise use of the terms "no recognition of post- valuation date credited service" and "recognition of post-valuation date credited service" in the determination of such plan features as the earliest unreduced early retirement date.(3)

One important problem created by the use of the expression "Retirement Method" is that it has fostered the opinion that it is also inaccurate to reflect the effect of future pre-retirement inflation measured by increases in the Consumer Price Index.

2. Calculations of Present Values of Pensions Usually Accurately Reflect Inflation Top of the Page

It is incorrect to believe that such a calculation is inaccurate. It is actually more accurate to reflect inflation than to try to calculate values which do not reflect inflation.

In the area of damages for personal injuries, an accurate allowance for future inflation is provided in Rule 53.09 of the Ontario Rules of Civil Procedure.(4) For over 25 years it has been recognized by investors and by the courts that there is no way to forecast annual inflation. It could drop to zero or it could increase to over 10%. Investors realize, however, that interest rates have historically always tended to exceed inflation by a small margin averaging 2 l/2% to 3 l/4% per year, referred to as the "real" rate of return on investments. Without this real rate of return, there would be no point in investing money. If interest rates simply matched inflation, the purchasing power of the investment would never increase.

The investor depends on the fact that, if inflation were to increase to 10%, interest rates would grow to average 12 l/2% to 13 l/4%.

When an actuary determines the present value of future pension payments or future costs of care to be provided for a disabled plaintiff, it is realized that if inflation grew to 10% the amount of money required in the future would be more substantial, but to offset this, the interest return to be expected in the future on the funds awarded would also be substantial so that a smaller amount is needed to be invested today to provide for the large future need for money. These two facts offset each other precisely. The present value required remains the same whether inflation declines to zero or increases to 10%.

The actuary makes the simple assumption that there will be no future inflation but that, as a result, interest rates will decline to 2 l/2% (or such other low discount rate as is required for personal injury damages in the specific province) or 3 l/4% (as required for pension valuation for equalization purposes with minor modifications for relatively few years after the valuation date). This is an accurate method for providing for future inflation in spite of the fact that such future inflation is unknown.

Calculations can only become speculative when an attempt is made to provide for productivity in excess of inflation by guessing the level of future salaries.

3. Public Sector Pension Plans (Government Employees and Teachers) Top of the Page

It is extremely important to recognize that there is a vast difference between public sector pension plans and private sector pension plans. Most public sector pensions are governed by two acts. For example, the Public Service Superannuation Act(5) describes the basic terms of the pension plan for federal government employees and the Supplementary Retirement Benefits Act(6) governs the additional terms of the pension plan which are designed to reflect inflation for federal government employees.

In the case of all public sector pension plans, full indexing for pre-retirement inflation, measured by increases in the Consumer Price Index, applies not only to those plan members who stay in the plan until retirement, but also to those plan members who terminate employment for any reason prior to retirement. On the other hand, it is extremely rare to find any allowance for pre-retirement inflation in a private sector pension plan once a member has terminated employment prior to retirement.

For example section 79 of Schedule 1 of the Teachers' Pension Act in Ontario provides as follows:

79.-(1) Every retirement pension, disability pension, survivor pension, child's pension and beneficiary's pension shall be adjusted for inflation in accordance with section 80.

(2) Every deferred pension payable under the pension plan shall be adjusted for inflation in accordance with section 80 for the period beginning at the end of the last month for which the member has credit under the plan and ending when the pension begins.

(3) No pension or deferred pension shall be adjusted under this section for inflation in respect of a period before the 1st day of January 1990.(7)

Section 80 of Schedule 1 includes the following definition:

"basic ratio", for a year, means the ratio expressed to three decimal places that the average for the Consumer Price Index over the last twelve months of the twenty-four-month period ending with the 30th day of September in the immediately preceding year bears to the average for the Consumer Price Index over the first twelve months of that period....(8)

The full text of Section 80 can be summarized by stating that each year on and after January 1, 1990 the pension is adjusted by the basic ratio with a maximum of 1.08 and a minimum of 1.00, with any basic ratio falling outside this range adjusted in later years by a carry forward formula. Similar indexing for the period prior to January 1, 1990 was provided by the Superannuation Adjustment Benefits Act.(9)

When the concept of placing values on pension plans for equalization purposes was first introduced, only a few actuaries had any experience with providing advice on public sector pensions. The vast majority of actuaries had confined their attention to private sector sections where pre-retirement indexing for inflation ceased on termination of employment. (The deferred vested pension provided for the private sector terminated member was not indexed for any further inflation prior to retirement.) A few early incorrect valuations of public sector plans found their way into case law, but after a few months all actuaries were properly reflecting full pre-retirement indexing for inflation in public sector pensions.

In those provinces where salary projection is not appropriate because family law never accepted speculative future productivity for promotions, all actuaries now recognize pre-retirement inflation in the case of all public sector pension plans by the accurate method of choosing a low "real" discount rate. Marsham v. Marsham was an early example of this technique in Ontario but the same technique is now applied to all public sector plans.(10) There is no real need to bring evidence to support pre-retirement indexing.

It is the consistent conclusion of all case law in Ontario that, in the case of public sector plans, it is essential to reflect full pre-retirement indexing for inflation as required by the precise terms of these plans but that it is inappropriate to reflect any future productivity in excess of such inflation.

Although those actuaries valuing the total liabilities of the pension plan for funding purposes will usually recognize both inflation and productivity in excess of inflation in developing salary scales, this technique can be considered inappropriate for family law purposes.

4. Hilderley v. Hilderley
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In Ontario, Hilderley v. Hilderley(11) is often quoted as an illustration that the "Termination Method" is to be preferred over the "Retirement Method".

Lawyers should remember however, that these two expressions have come to have several definitions and must look more closely at the particular definition intended.

The "Termination Method" sometimes implies that the employee terminated employment on the valuation date and that it would be inappropriate to include any allowance for any pre-retirement inflation.

This definition does not apply in Hilderley v. Hilderley because Mr. Hilderley was a school principal, participating in the Ontario Teachers' Pension Plan, a public sector plan where, by the definition of the plan, future increases to reflect pre-retirement inflation automatically apply whether Mr. Hilderley terminated employment on the valuation date or continued employment until later retirement.

The "Retirement Method" sometimes implies that it is appropriate to allow for pre-retirement inflation and future productivity by projecting the likely future earnings of the employee until the assumed retirement date and then determining the appropriate part of the deferred annuity so calculated which is applicable to the period of marriage.

Hilderley v. Hilderley was clearly rejecting this "Retirement Method" because such method allowed the spouse to share in the fruits of the employee's labour after the marriage had ceased and because it involved speculative projections of future salaries.

The ultimate point established by Hilderley v. Hilderley is that the recognition of the pre-retirement inflation indexing required by the plan (regardless of whether the employee terminated employment on the valuation date or remained in the plan until retirement) must be calculated by a method that uses the deferred annuity accrued to the valuation date, as if employment had terminated at the date of valuation, without any speculative projection of salaries, and avoids any post-valuation productivity reflecting the fruits of the employee's labour after the valuation date. This is accomplished by adopting the simple expedient of using a low discount rate.

Now that it is established that, for all plans in Ontario, no recognition should be given in Family Law Act calculations to any productivity of the plan participant after the valuation date, there is no longer any need to continue the confusing expressions "Termination Method" and "Retirement Method" in the specific case of public sector plans. The result of the "Termination Method" is identical to the result of the "Retirement Method" except for rare plans where the deferred annuity arising from an early termination is indexed prior to retirement, but not indexed after retirement.

In both cases full pre-retirement indexing must be used. The actuarial valuation is based on the pension accrued to the valuation date reflecting the average of the best five years earnings prior to the valuation date using a low discount rate to reflect the fact that most of the interest earned will be required to provide for the effect of inflation. As stated earlier, it would be better to employ more specific terms such as whether or not "speculative productivity" in excess of inflation should be recognized.

5. Public Sector Case Law is Inappropriate for Private Sector Plans Top of the Page

Over 95% of all reported case law deals with the large public sector plans where the question of whether or not the plan participant terminated employment on the valuation date is of no concern in the choice of pre-retirement indexing, as the actuarial valuation is the same regardless of the answer to the question, and the use of the ambiguous term "Termination Method" has led to so much confusion. Such case law should not be used as illustrative of appropriate case law for private sector plans, particularly since, as long as the actuarial evidence demonstrated that the low "real interest" discount rate could be used to accurately reflect inflation, there is no case law deliberately rejecting pre-retirement indexing for inflation.

This confusion was originally created by incomplete actuarial evidence. Any future decisions which purport to create or reverse case law for private sector pensions using case law developed for public sector pensions will invariably be found to be based on incomplete actuarial evidence or incomplete arguments.

6. Private Sector Pension Plans
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Private sector plans are the only plans where the question arises of whether or not to allow for pre-retirement indexing, and where there is any real reason to present evidence on whether it is appropriate to reflect pre-retirement inflation.

7. Employer Contributions to the Assets of Final Average Plans Reflect Pre-Retirement Indexing Top of the Page

All pension plans must retain an actuary at least every three years to calculate the liability required as sufficient to pay all future plan benefits, and to calculate the appropriate employer contributions required to increase the current plan assets to the point sufficient to cover such liabilities.

Pension authorities review these calculations. For example, in Ontario, the Superintendent of Financial Services is responsible to the Ontario Minister of Finance for enforcing the Ontario Pension Benefits Act.(12)

In the case of final average salary plans the actuary is required to calculate liabilities allowing for future pre-retirement indexing. The actuary is never permitted to make the unrealistic assumption that all employees will terminate employment on the valuation date.

This implies that the calculation of employer contributions reflects full pre-retirement indexing. The plan is holding assets for every plan member sufficient to provide full pre-retirement indexing for inflation. Once employer contributions have vested, all the benefits derived therefrom (including full indexing of the pension up to retirement in the case of a final average salary plan) are the property of the employee. To protect the solvency of the plan, employer liabilities, and consequently employer contributions, are calculated taking into consideration the assumption of indexing for inflation prior to retirement.

The required plan liabilities applicable while employees are still active are considerably higher than the low transfer values that would be paid if the plan member terminated employment prematurely.

In the case of family law, it is important to introduce evidence to explain that indexing for inflation required for final average earning plans can be accurately reflected by the use of a low discount rate. There is no Ontario case law, where such evidence has been given, which deliberately required the elimination of pre-retirement indexing for inflation, should the member remain in the plan to retirement - only case law rejecting future productivity in excess of inflation. When we turn to the Ontario Family Law Act, it includes employer contributions (and their dependence on pre-retirement indexing) in the definition of family property as it reflects the pension plan values.

"property" means any interest, present or future, vested or contingent, in real or personal property and includes,

. . . . .

(c) in the case of a spouse's rights under a pension plan that have vested, the spouse's interest in the plan including contributions made by other persons.(13)

We can condense this section in one sentence:

The value of a vested member's pension at the valuation date is defined by the Family Law Act to reflect not only the employee contributions but also the employer contributions; in effect, this is the total liability defined by the provincial Pension Benefits Act to provide for all future benefits to the member for service during the marriage, including the recognition of the fact that the ultimate benefit at retirement will reflect full pre-retirement inflation.

8. Ontario Case Law On Private Sector Plans
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The only appropriate case law in Ontario for private sector plans is based on the relatively few reported cases such as Halman v. Halman and Bascello v. Bascello(14) that deal specifically with private sector pension plans.

In these two cases clear evidence was presented that

  • the calculation of employer contributions invariably takes into consideration full pre-retirement indexing;
  • this can be accurately reflected by using a low real interest rate;
  • (In rare cases, where the actuary was not familiar with this technique and incorrectly stated that speculative salary projections were required whenever it was assumed the employed would continue to participate in the plan, this speculation was rejected.)
  • had termination occurred on the valuation date, there would have been no further pre-retirement indexing of the deferred pension commencing at retirement; but that
  • should the employee remain in the plan until retirement, full pre-retirement indexing for inflation would be appropriate for these final average salary plans.

In other words, a range of possibilities should be considered. In both these cases the court agreed there were two extremes and that a compromise value between the two was appropriate.

In the case of Bascello v. Bascello the value was obtained by first selecting the value based on full pre-retirement indexing and then reducing such value by a contingency deduction equal to 30% of the difference between: (1) the value based on full pre-retirement indexing, and (2) the value based on no pre-retirement indexing, to provide for the contingency that the plan member might terminate employment prior to the age at which a retirement pension would have been available.

It is my opinion that, in the case of private sector plans, the actuary should present pension values for family breakdown based on two assumptions:

  • no pre-retirement indexing.
  • full pre-retirement indexing.

The first is completely biased in favour of the plan participant and is appropriate only if there is an imminent risk of he or she being laid off. The second is biased in favour of the spouse of the plan participant and is appropriate only if the plan member stays employed to retirement. The two sides should negotiate a reasonable compromise between these two extremes, just as they would negotiate a reasonable compromise between values assuming different retirement ages.

Footnotes
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(1) Early cases allowing no productivity. The basic pension to be valued should be based on earnings prior to the valuation date, with no speculative allowances for future productivity. See Humphreys v. Humphreys (1987), 7 R.F.L. (3d) 113 (Ont. H.C.); Stokes v. Stokes (1986), 8 B.C.L.R. (2d) 80, 6 R.F.L. (3d) 342 (B.C.C.A.), leave to appeal refused (1987), (sub nom. Cameron v. Stokes) 79 N.R. 318 (note) (S.C.C.); Hilderley v. Hilderley (1989), 21 R.F.L. (3d) 383 (Ont. H.C.).

(2) R.S.O. 1990, c. F.3.

(3) Cases where, instead of assuming termination of employment at the valuation date, the member was assumed to continue employment, earn further service credit toward qualification for early retirement, and retire at one of a number of later dates, including the earliest unreduced early retirement date. However, the principle of no speculation of post-valuation productivity was preserved. See Miller v. Miller (1987), 8 R.F.L. (3d) 113 (Ont. Dist. Ct.); Hilderley v. Hilderley (1989), 21 R.F.L. (3d) 383 (Ont. H.C.); Alger v. Alger (1989), 21 R.F.L. (3d) 211 (Ont. H.C.); Deroo v. Deroo (1990), 28 R.F.L. (3d) 86 (Ont. H.C.) Weaver v. Weaver (1991), 32 R.F.L. (3d) 447 (Ont. Gen. Div.); Belyea v. Belyea (1990), 111 N.B.R. (2d) 300, 30 R.F.L. (3d) 407 (N.B. Q.B.); Carrol v. Carrol (1989), 102 A.R.97, 24 R.F.L. (3d) 65 (Alta. Q.B.); Halman v. Halman (1993), 1 C.C.P.B. 268 (Ont. Gen. Div.) (Q.L.); Radcliff v. Radcliff (1994), O.J. No 2874 (Gen. Div.) (Q.L.); Weise v. Weise (1992), 99 D.L.R. (4th) 524, 12 O.R. (3d) 492, 44 R.F.L. (3d) 22 (Ont. Gen. Div.); Salib v. Cross (1993), 15 O.R. (3d) 521 (Ont. Gen. Div.), affirmed (1995), 18 R.F.L. (4th) 218 (Ont. C.A.) (Gen. Div.) (Q.L.); Dick v. Dick (1993), 46 R.F.L. (3d) 219 (Ont. Gen. Div.) additional reasons at (May 27, 1993), Doc. Ottawa 40021/90 (Ont. Gen. Div.).

(4) R.R.O. 1990, Reg. 194.

(5) R.S.C. 1985 c. P-36.

(6) R.S.C. 1985 c. S-24.

(7) R.S.O. 1990, c. T.1, s.79.

(8) R.S.O. 1990, c. T.1, s.80

(9) R.S.O. 1990, c.490

(10) Public sector cases allowing no productivity but with plan terms correctly reflected by adjusting the basic pension by an allowance for full pre- retirement indexing. The actuary would have chosen to use a low interest rate assumption representing the balance remaining, after subtracting from the total interest rate that part required to cover inflation, and would probably have explained this low real interest rate assumption in court.

A list of such cases would include all public sector cases valued after the introduction of the C.I.A. Standard of Practice September 1, 1993. Two sample cases are: Marsham v. Marsham (1987),38 D.L.R.(4th)481, 59 O.R.(2d) 609, 7 R.F.L.(3d) 1(Ont. H.C.); and Salib v. Cross (1993), 15 O.R. (3d) 521 (Ont. Gen. Div.), affirmed (1995), 18 R.F.L. (4th) 218 (Ont. C.A.) (Q.L.).

(11) See above, note 3.

(12) R.S.O. 1990, c. P.8.

(13) R.S.O. 1990 c. F. 3, S.4/

(14) Halman v. Halman (1993), 1 C.C.P.B. 268 (Ont. Gen. Div.)(Q.L.); Bascello v. Bascello (1995), 26 O.R. (3d) 342 (Ont. Gen. Div.), additional reasons at (1995), 18 R.F.L. (4th) 362 (Ont. Gen. Div.), Further additional reasons at (1996), 9 O.T.C. 384 (Ont. Gen. Div.)