IV. VALUATION OF RIGHTS UNDER A PENSION PLAN

IV. VALUATION OF RIGHTS UNDER A PENSION PLAN2017-03-03T18:30:50+00:00
Valuation of rights under a defined contribution plan generally poses few problems; the value for net family property purposes is simply the aggregate of the contributions made during the marriage and the returns on investment of those contributions as of the valuation date. With a defined benefit plan, however, this “contributions approach” plainly does not provide an appropriate value, because what the plan member is entitled to by way of a pension has no immediate relation to the accumulated contributions and investment yield; rather, the pension entitlement is determined according to a set formula, typically based on years of service multiplied by some specified percentage of the average of the member’s earnings in his final few years of employment. Equating the value of such an entitlement to the sum of contributions made plus the return on their investment is likely to understate considerably its true worth.[127] A different approach must be used.

A. Present Value

To produce a figure that can appropriately be attached to a defined benefit pension for equalization purposes requires that its “present value” (sometimes called “present-day capitalized value”)[128] be determined. The present value of a stream of payments that are to begin at some point in the future may be thought of as the amount that one would have to invest today so that as of the date the payments begin the original investment plus accumulated earnings would be exactly sufficient to cover all of the payments that are to be made as they come due. In the particular context of marriage breakdown and defined benefit pensions, the present value as of the valuation date is the amount that would have to have been invested on that date in order for the original investment and accumulated earnings to be just adequate to fund the monthly benefits when the pension comes into pay.[129] Of course, this figure is necessarily the product of conjecture. On the valuation date, the person performing the valuation[130] does not know when the pension payments will begin (given that the date of retirement is unknown on that date) or even whether they ever will begin (given the possibility that the employee will die first) or if they do begin how long they will last (given that the date of death is unknown), nor does she know how much any given investment will ultimately earn (given that tomorrow’s interest rates and inflation levels are unknown); lacking omniscience concerning the future, the valuator must make speculative assumptions about all of these variables. As the Supreme Court of Canada has noted, ascertaining a present value is “a matter of educated guesswork, undertaken by actuaries”. [131]

B. Methods of Valuation

Although there seems to be little doubt today that the present value approach is to be preferred over the contributions approach in valuing rights under a defined benefit pension plan,[132] at least some uncertainty regarding the methodology used to calculate a present value continues to exist. Neither the FLA nor the PBA provide any guidance as to how pension rights should be valued for purposes of calculating net family property,[133] and so the question of how it should be done has been left to be answered by the parties, their lawyers, actuaries or other pension valuators and, ultimately, the courts. Debate on the issue has typically been framed as a matter of whether to use the “retirement method” or the “termination method”.[134] However, there is some considerable ambiguity in these terms, and it is not always clear what a court means when it declares that one or the other method is being utilized. Indeed, it has been suggested that in many cases in which the termination method was ostensibly used, the method that was actually being employed was the “real interest method” (also known as the “hybrid termination-retirement method”).

C. Retirement Method v. Termination Method

The retirement method assumes that the employee will continue in her employment with the plan sponsor until reaching some specified retirement age selected by the valuator. Accordingly, the basis on which value is calculated includes projections as to future salary increases, both those that are rooted in inflation and those that are based on promotion or productivity increases, as well as future service credit accruals and possible future enhancements to members’ rights under the plan. In contrast, under the termination method, the amount of the future pension entitlement is said to be assessed as if the pension plan member had terminated her employment on the valuation date. This means that only those service credits accrued to the valuation date are taken into account; it would also seem to imply that no consideration is given to the possibility of salary increases or plan improvements that may occur after that date.

If one goes strictly by the labels employed by Ontario courts to describe their preferences in valuation methodology, the termination method seems generally to have found much more favour than the retirement method, although the view that it represents the better approach is by no means universal. (Indeed, the Supreme Court of Canada has raised the possibility that the retirement method might provide an appropriate result in at least some circumstances.)[135]

Two main arguments have been advanced in support of the termination method over the retirement method. The first is that by projecting salary levels and service credits that might be earned after the valuation date, the retirement method gives the non-member spouse the “fruits” of the member spouse’s post-separation labours and is therefore in conflict with the FLA requirement that value be determined as of the valuation date.[136] How valid an objection this is can be debated. While the retirement method undeniably looks to post-separation events (or rather, assumptions about post-separation events), the “years of service” multiplier used in a defined benefit plan formula does not assign any greater weight to the final years of the member’s time with the plan sponsor than to the early years[137] (although the dollar multiplicand employed in the formula obviously would be based on post-separation salary levels).

The second principal objection to the retirement method concerns its highly speculative nature, resulting from the fact that it requires the making of assumptions as to what the member spouse’s salary and service credits will be and what plan improvements will have been made by the time he does retire.[138] These assumptions will virtually never have a perfect correspondence with future facts as they unfold and they may not even be close. Still, the termination method also involves the making of many assumptions that may not be borne out by subsequent developments. In order to produce a present value, the termination method, like the retirement method, must employ assumptions about when (and if)[139] the member spouse will retire and about how long he will collect the pension; assumptions are also made about future rates of interest and taxation. Any of these assumptions could turn out to be “incorrect”, in the sense that events might unfold differently than was assumed, and in fact they will in that sense almost certainly prove to be incorrect in any individual case, notwithstanding their validity from an actuarial point of view. And, if subsequent events do diverge significantly from what was assumed, the actual value of the pension benefit and the value it had been considered to have had for equalization purposes could deviate quite dramatically, to the great disadvantage of one or the other spouse. For example, if the member spouse collects the pension for a longer period than that on which the valuation was based, the actual value of the pension rights may end up exceeding, perhaps by a quite considerable amount, that which was attributed to them as net family property.

D. Do the Courts Really Favour the Termination Method?

In Bascello v. Bascello,[140] a number of previous decisions of Ontario courts purporting to apply the “termination method” were reviewed and the conclusion offered that most of those courts were not in fact using a true termination method but the “real interest method”. Under this approach, while the valuation is based on the pension entitlement accrued to the valuation date, allowance is made for inflation (at least in the case of fully-indexed plans, as most public sector plans are);[141] it is only non-inflationary increases in salary, such as those stemming from promotions and productivity improvements, that are not taken into account. (The real interest method takes its name from the fact that it allows for inflation by employing a discount based on the difference between inflation rates and nominal interest rates, which over the long term has been relatively constant despite whatever fluctuations were occurring in the nominal rates.)[142]

Another feature of the approach typically employed by Ontario courts that Bascello identified as being inconsistent with a pure termination approach lies in the treatment of rights that an employee may have under the pension plan to take early retirement without any reduction in the defined benefit. While courts that purport to apply the termination method do not take into account any actual or assumed post-valuation date employment for purposes of calculating the amount of the pension, in the majority of cases that have dealt with pension plans having an unreduced early retirement option the courts did assume that the employee’s employment would continue for the purpose of eligibility to exercise such an option in order to determine the date on which the employee would be most likely to retire.

The impact of this approach can be illustrated with the example of an employee who has twenty-one years of service and who is 45 years old as of the valuation date and whose pension plan establishes a normal retirement date of age 65 but also accords a right to take early retirement without penalty if the employee meets a “factor 90” qualification. A valuation based on a pure termination method would ignore the unreduced early retirement possibility, as the stated premise of the termination method is that the future pension entitlement is assessed as if the pension plan member had terminated her employment on the valuation date, and in that case the employee in our example would reach the normal retirement date before achieving factor 90.[143] Nevertheless, although the amount of her pension entitlement for valuation purposes will be based on her years of service as of the valuation date, most courts will posit continued employment after the valuation date and eventual qualification for an unreduced early retirement pension (in the case of the employee in this example, at age 57)[144] for the purpose of selecting the date on which the employee is most likely to retire.[145] (Objections that the member spouse’s employment may terminate prior to retirement because of lay-off or other reasons are typically addressed by using a discount for that possibility.)[146] This can have a very substantial impact on the valuation, because where an employee retires before the normal retirement date, the pension is likely to be in pay for a longer period than it otherwise would, thereby increasing the value.[147]

The approach used in Bascello and in the majority of the other cases discussed in that decision appears to have become the dominant approach to pension valuation in Ontario. Although Bascello referred to this as the “real interest method”, some commentators have labelled it the “hybrid termination-retirement method”, as it combines elements of both the termination method (in that termination at the valuation date is assumed in order to determine the amount of the accrued pension benefit) and the retirement method (in that inflation is recognized where the plan is indexed and continued employment is assumed for purposes of eventual eligibility to take early retirement on an unreduced pension).[148] The Bascello court was highly critical of this terminology, arguing that the expressions “termination method”, “retirement method” and “hybrid termination-retirement method” did not adequately convey the actuarial assumptions being utilized; it recommended instead that the method of valuation be described in terms of whether allowance was being made for full, partial or no indexing prior to retirement.[149] With respect, however, a description of the sort espoused in Bascello is also inadequate, in that it fails to give any indication of how unvested unreduced early retirement rights are to be treated. Perhaps it is simply not possible to devise terms that are at once both reasonably concise and comprehensively significative. In any event, although the labels “termination method”, “retirement method” and “hybrid termination-retirement method” may not be entirely satisfactory, they do at least impart some idea of the underlying principles, with “hybrid” suggesting a middle ground between two conflicting and more radical approaches. For that reason, those terms will be used in this report.

In its 1993 Standard of Practice for the Computation of the Capitalized Value of Pension Entitlements on Marriage Breakdown for Purposes of Lump Sum Equalization Payments, the Canadian Institute of Actuaries referred to both the “termination method” and the “retirement method”, indicating that the choice of method would depend on the jurisdiction in which the division or equalization of family property was taking place.[150] That terminology does not appear in section 4300 of the Institute’s Standards of Practice, which superseded the original marriage breakdown standard, but it would appear that the choice of method continues to be left as a matter for the law of the jurisdiction concerned rather than a subject of professional prescription. The current standard indicates that an actuary might produce more than one figure in valuing a pension because of the treatment of possible future salary increases, both those that are inflation-based and those that are productivity-based;[151] it also states, insofar as the age of retirement is concerned, that an actuary would usually report a number of different values based on a range of retirement ages, including the normal retirement date, the earliest age at which the member could elect an unreduced pension assuming termination of employment at the valuation date and the earliest age at which the member could elect such a pension assuming that employment continues beyond the valuation date.[152] Obviously, the current standard is flexible enough to accommodate use of any of the termination method, the retirement method or the hybrid method.

Despite Bascello and a number of other cases that seem to reject, in substance if not in name, the termination method (at least in its pure form), this area of the law cannot be regarded as entirely settled. In Salib v. Cross,[153] decided after Bascello, the Ontario Court of Appeal approved the trial court’s use of a quite stringent termination approach in which the member spouse’s pension was valued on the basis that she would retire on a reduced pension, even though the retirement date was assumed to be the day on which she would first qualify for an unreduced pension;[154] approaches that would have resulted in a higher valuation were rejected on the basis that they were too speculative, given that on the facts before the court considerable post-valuation date service would have to be assumed. On the other hand, as was noted above, the Supreme Court of Canada in Best v. Best indicated that the retirement method might be appropriate in some circumstances. Thus, it appears that while the hybrid termination-retirement method is the most frequently used, a court has discretion to employ the termination method or the retirement method if it thinks that that method produces the fairest result in a particular case.[155] However, this means that some uncertainty about how a defined benefit pension should be valued for family law purposes continues at a fundamental level.

E. Pre-Marriage Accruals

One valuation issue in respect of which there is certainty concerns the situation in which the member spouse joined the pension plan prior to the marriage. This requires setting a value on the pension rights not only as of the date of separation but also as of the date on which the spouses married, because the FLA requires that the value of property owned on the marriage date be deducted in calculating net family property. Two approaches for addressing this situation have been put forward, the “pro rata approach” and the “value added approach”. Under the former, the separation[156] date value is multiplied by the quotient obtained when the number of years of pensionable service during the marriage is divided by the total number of years of pensionable service as of separation. In contrast, the value added approach involves separate actuarial valuations for the marriage date and the separation date. (In other words, the marriage date value is not simply a derivative of the separation date value.) The pro rata approach tends to produce a higher value as of the marriage date than the value added approach, which necessarily results in a lower value being attributed to the portion of the pension that accrued during the marriage, and some have argued that the failure to provide a separate valuation as of the marriage date is not in accord with what the FLA requires;[157] however, the pro rata method was approved by a majority of the Supreme Court of Canada as generally being the fairer approach in Best v. Best.[158]

F. Valuation Assumptions: the Age of Retirement

As has been noted, the assumption that is made concerning the age at which the employee is likely to retire can have a very substantial impact on the valuation of the member spouse’s rights under a defined benefit plan; the earlier the retirement date, the longer the pension payments will continue to be made and hence the greater the value attributed to those rights. This leads to the possibility that the member spouse and the non-member spouse will put forward opposing, self-interested positions as to the likely retirement date. The member spouse, desiring a lower value, may assert that he does not plan to retire until the normal retirement date or later, while the non-member spouse, wanting a higher value, may contend that the member always intended to retire at the earliest date on which an unreduced pension could be taken.

In several cases decided soon after the coming-into-force of the FLA, it was held that where there is a conflict in the evidence that is presented in relation to the likely retirement date, it should be presumed that an employee will retire at the earliest date on which she would become eligible to take an unreduced pension.[159] In other early cases, courts ruled that in the event of such conflict valuation should proceed on the basis that the employee would retire at the mid-point between the earliest unreduced pension date and the normal retirement date.[160] However, in two 1996 decisions,[161] the Ontario Court of Appeal rejected these approaches, holding that a trial court must make a finding respecting the likely date of retirement on a balance of probabilities on the basis of the evidence before it. This stance appears to have been given implicit approval by the Supreme Court of Canada in the Best case;[162] that Court went on to hold that where the termination method[163] is used in valuing pension rights no consideration should be given to post-valuation date evidence in selecting a probable retirement date,[164] as the acceptance of such evidence might encourage “strategic behaviour”[165] (such as the member spouse purportedly resiling from a previously-announced intention to take retirement as soon as she qualified for an unreduced pension).

There is no question, of course, that a court should retain a healthy skepticism where self-serving evidence is adduced by a party to a dispute. However, the fact that marriage breakdown generally carries with it adverse financial consequences means that plans regarding retirement may of necessity have to be postponed — query whether decisions to delay retirement in such circumstances should really be seen as a matter of post-valuation date evidence, even if not fully formed or articulated until some time after separation when those consequences have been made clear. (Looking at this another way, realistically speaking separation will in many cases have the immediate effect of making it difficult or impossible for the member to retire as early as he had originally planned, even though he might not yet have turned his mind to the issue on the day of separation.) To found a valuation on a presumed retirement date chosen on the basis of vague statements of intention made in the past when it would (or does) fall well before the date on which the employee actually will (or did) retire means that the value of the pension rights will be significantly overstated at the expense of the member spouse. On the other hand, there is an obvious danger of unfairness to the non-member spouse in taking the member’s post-separation evidence of his retirement plans at face value.

Such considerations may seem to favour the establishment of a statutory presumption based on the mid-way point between the earliest date on which the member can retire on an unreduced pension and the normal retirement date set out in the plan.[166] However, there are numerous situations in which such a presumption would not be workable or would produce inequitable results. Some plans do not have an unreduced early retirement option. Some plans offer such options, but attach conditions at some ages and not at others. Some plans put a limit on the accrual of service credits, leading to the possibility that the limit would be reached before the mid-point.[167] Some plans may to some extent subsidize early retirement at ages earlier than the “unreduced” age, imposing a reduction that is less than a full actuarial reduction, such that the value of the reduced pension could actually be greater than the pension that would be available when the member reaches the earliest age at which an unreduced pension can be taken. And in some cases the member may have joined the plan at a very late stage in her working life, making it virtually inconceivable that she would retire at the mid-way point. Given the complexity and diversity of pension plan options and the multitude of different factual circumstances that could arise, the LCO is not convinced of the merits of a presumption regarding retirement age. In our view, any issue as to when a member will retire should continue to be treated as a question of fact, resolved on the basis of the evidence according to the balance of probabilities.

G. Other Valuation Assumptions

Just as assumptions regarding the date on which the member spouse is likely to retire will affect the value attributed to the member’s pension rights (in that the earlier the retirement date, the longer the pension is likely to be in pay and accordingly the higher its value), assumptions regarding the date on which the member spouse will die will also affect the value (in that the earlier the date of death, the shorter the period in which the pension will be in pay and accordingly the lower its value). However, pension valuators generally do not attempt to make individual-specific predictions about death;[168] rather, they rely on mortality tables, which purport to indicate the probability of death within one year at each age in the human life span for a large population (typically, 1,000 persons). Using such a table, the valuator takes into account the probability of the member surviving to any given year.

Some of the literature expresses criticism of various mortality tables that have been used.[169] The ones developed for life insurance purposes and annuity purposes are said, respectively, to overstate or understate the death rate in order to be conservative and allow a margin for profit;[170] using those tables would result in, respectively, a lower or higher value for the pension, thereby disadvantaging one or the other spouse. Statistics Canada tables are based on the general population, which, because that population includes persons not working because of health problems, may overstate the rate of death.[171] Paragraph 4330.02 of the Canadian Institute of Actuaries’ Standards of Practice states that actuaries should assume death rates in accordance with a mortality table prescribed by the Institute’s Practice Standards Council, modified where warranted if the member is in poor health. At the date of writing the prescribed table is a group annuity mortality table;[172] however, the LCO understands that the Institute is reviewing this matter.

Another assumption that a pension valuator might make concerns income tax. The fact that the pension will be subject to taxation when it comes into pay means that its actual worth to the member will be something less than its before-tax value,[173] and the Ontario Court of Appeal has held that valuation of a pension should reflect a deduction for the tax that is likely to be paid.[174] The Canadian Institute of Actuaries Standards of Practice specifies that where tax is to be taken into account, the deduction should be based on the member’s average (as opposed to marginal) rate of tax, calculated on the basis of her anticipated income once retired but assuming continuation of the existing taxation rules as to rates, brackets and other matters.[175]

As was noted above, the present value of the member spouse’s rights under a defined benefit plan as of the valuation date is the amount that would have to have been invested on that date in order for the original investment and accumulated earnings to be just adequate to fund the monthly benefits when the pension comes into pay. Determining this amount requires the making of assumptions respecting interest rates in order to project a notional investment yield. In that regard, the Standards of Practice prescribe different approaches for indexed and non-indexed pensions.

For indexed pensions, the assumed rate of interest for the first fifteen years following the valuation date is based on the interest rate offered on long-term Government of Canada real return bonds in the second month before the month in which the valuation date occurs; for subsequent years, the valuator assumes a rate of 3.25%, representing what might be viewed as the “real interest rate” or “net interest rate” (that is, the rate representing what historically has been the relatively constant spread between inflation rates and nominal interest rates). For pensions that are not indexed, the assumed interest rate for the first fifteen years is based on the rate offered on long-term Government of Canada conventional bonds; after fifteen years an interest rate of 6.25% is assumed, reflecting the average historical yield on long-term Government of Canada bonds that are not real return bonds.[176] In both cases, using a rate on offer around the time of valuation for the first fifteen years and thereafter a fixed rate based on historical data reflects a view that the impact of short-term market fluctuations should be recognized but that those fluctuations will tend to cancel out over the longer term. Other factors being equal, the differential treatment of indexed and non-indexed pensions insofar as interest rate assumptions are concerned will tend to produce a higher value for an indexed pension than a non-indexed pension, as obviously is appropriate.

In the case of some pension plans, members may not be entitled to have their pension benefits indexed, in that they have no contractual right to indexing, but the plan sponsor may nonetheless have a practice or policy of increasing benefit amounts from time to time to offset, to some extent at least, the impact of inflation on the real value of the pension income. Whether the pension is valued for equalization purposes as an indexed or non-indexed pension in such a case would appear to depend on how established or settled the practice or policy is.[177]

H. Do So Many Assumptions Rob Valuation of Its Legitimacy?

It is quite evident that valuation of a pension involves the making of many assumptions. As was noted above, any of these assumptions could turn out to be “incorrect”, in the sense that events might unfold differently than was assumed; in fact they will in that sense almost certainly prove to be incorrect in any individual case, however sound the assumptions may have been from an actuarial standpoint. But does this make valuation illegitimate?

If subsequent events do diverge significantly from what was assumed, the ultimate real value of the pension benefit and the value it had been considered to have had for equalization purposes could deviate quite dramatically; understandably, this can cause resentment on the part of the “loser” spouse. However, if rights under defined benefit pension plans are to be considered property for purposes of the FLA equalization regime, they obviously must be valued, and given that the contributions method is plainly not an appropriate valuation method for such plans, it is difficult to see how these rights could be valued without resort to assumptions. (Indeed, the only way that one could obtain a value that is not based on assumptions and that matches exactly what the member ends up receiving from the plan would be to postpone valuation until the day the member dies — clearly not a useful approach for equalization purposes.)[178]

One should also keep in mind that many assets, and not just rights under a pension plan, could ultimately prove to have a greater or lesser value than that which was attributed to them at equalization. The price of shares might plunge in a post-valuation day bear market; a matrimonial home might sell for much more than its equalization value if housing prices are bid up after valuation day — though these possibilities (or their opposites) come to pass, the valuation day values are not thereby rendered illegitimate. If pensions are to remain within the equalization regime, they must be valued, and with valuation comes the risk (indeed, virtual inevitability) of post-equalization changes in value, as it does with any property. The real problem with equalization insofar as pensions are concerned lies not in their valuation, but with settlement.

Previous Next
First Page Last Page
Table of Contents