When interest rates rise
October 24, 2013
You've added another year of service to your pension, your average salary increased from the year prior, so why might the commuted value of your pension be lower?
Each fall, we prompt you to do a pension check-up. What's involved? Once a year you receive a Personal Statement of Benefits (PSOB). This statement reflects what you've earned in the pension plan so far, and may include a projection of your future pension benefits.
If you're a typical working plan member, there's a good chance that you have another full year of service under your belt and that your average salary is higher than the year prior. Keeping this in mind, common sense would dictate that the commuted value of your pension, or the lump sum needed today to replace your future pension, would also increase.
This isn't necessarily the case, though. When interest rates increase, your pension's commuted value decreases.
Think of a pension income stream as a mortgage spread out over 20 years, (not taking into account any indexing that would be applied to your pension).
You go to the bank and tell them you're comfortable paying $2,000 a month towards a mortgage for the next 20 years. At a 4% interest rate, you would be able to buy a house worth about $332,000.
If the interest rate increases to 5%, you would only be able to afford a home around $306,000.
Our pension plan is highly sensitive to fluctuations in interest rates. When rates go up, our liabilities – i.e. pension values – go down. Just like when bank mortgage interest rates go up, the value of the home you can afford to buy goes down.
How will this affect you?
Ups and downs in your commuted value between now and retirement will not affect how your pension is calculated. If you're like the vast majority of our plan members, you'll retire and collect a monthly pension benefit. Since our plan is a defined benefit plan, your monthly pension benefit is calculated based on a formula that takes into account the average salary of your "best 5" years and the number of years that you've contributed to the plan. Unless you're planning on leaving your career in education before retirement and cashing out the commuted value of your pension, you won't be affected.
The rates and assumptions used by Teachers' when calculating your commuted value are prescribed by the Canadian Institute of Actuaries and change each month as the bond yields change.