We are very much aware of the role inflation plays in eroding the real value of pensions that do not increase after retirement. A pension that was considered adequate at the time of retirement loses its purchasing power as time goes by and may gradually become inadequate. Government pensions (such as CPP or OAS) are increased each year to reflect the increases in the Consumer Price Index (CPI). Private pension plans cannot afford to provide such automatic indexation – the costs could become prohibitive in times of high inflation. In order to contain such costs, many private pension plans grant pension increases on an ad hoc basis or use an approach that is known as “excess interest” approach. This provides a good means for mitigating the effects of inflation in a meaningful manner.

Under the “excess interest” approach, the reserves at retirement are set up at a rate of interest that can be expected to be earned during periods of zero inflation – say, 4% (called the “base rate”). The expectation is that in times of zero inflation, this rate will be earned and the pensions can be maintained at the initial level (because of zero inflation, there will be no need to increase the pensions). In inflationary times, the pension fund will be expected to earn an appropriately higher interest rate. For example, if inflation runs at 5% and the fund is able to earn an interest rate of at least 9% (base rate of 4% plus the inflation rate of 5%), the additional interest (in excess of 4%) earned by the fund can be used to increase the pensions by 5%; thus negating the effect of inflation. Such pension increases would not require any additional funding to the pension plan. The excess of the fund yield over the base rate of 4% is known as “excess interest rate”. The expectation in the long term would be that the “excess interest rate” would be at least equal to the CPI increase rate – but there may be some years when this may not be true.

Indexation of Canada Life Pensions

When Canada Life set up the defined benefit pension plan in 1965, a provision was made to index pensions after retirement. This indexation was based on the “excess interest” approach described above, using 4% interest rate as the base rate. It should be noted that the benefit of pension indexation is not available to the members who joined the pension plan on or after January 1, 2000.

For many years following the inception of the pension plan, the inflation rates exceeded the “excess interest rates” and the pension increases could not keep up with inflation. Beginning with the early eighties, the “excess interest rates” exceeded the inflation rates, and the pension increases began exceeding the inflation rates and the past deficiencies were made up, with a result that for most of the present retires, the pensions have been increased to reflect the full effect of inflation since their respective dates of retirements.

In order to comply with the provisions of the Income Tax Act, a change was made to the pension plan in the mid-eighties, which stipulated that the pension increase in any year cannot be greater than the increase warranted by the increase in the CPI. This limitation was to be based on a cumulative basis since retirement. This limitation created a phenomenon of “catch up room”. Assume that in one year, the CPI increase rate was 3% and the fund yield was 9%, making the “excess interest rate” equal to 5% (9% minus 4%). This meant that even though the pension fund could afford to increase the pensions by 5% (without causing any strain on the fund), the increase had to be limited to 3%. The excess interest earnings of 2% would be left in the fund and would be available for use in a later year when the CPI increase rate exceeded the “excess interest rate” for that year. In such a year, the fund will be able to grant an increase greater than that warranted by the “excess interest rate” to the extent the “catch up room” was available. If the CPI limitation is applied for a number of years, it creates a sizable amount of “catch up room” for the pensioners. This provides a valuable protection to the retirees if the pension fund is not able to keep up with inflation in the future (through appropriately higher yields on assets).

An article published in April 1996 in the Pelican Post gives a detailed description of how the indexation has worked in the past.

How the Canada Life Indexation Works

Assume that the rate of pension increase from January 1, N (the current year) is to be calculated. For this purpose, the earned rate of interest and the inflation rate for the immediately preceding year (N-1) are to be used. The “excess interest rate” is calculated to be equal to the earned rate of interest minus 4%. The following possibilities can arise in calculating the maximum increase:

The “excess interest rate” can be 6.5% and the inflation rate 3%. Since the pension increase cannot exceed the inflation rate, the maximum pension increase will be 3%. The balance of 3.5% will go into the “catch up room” for each pensioner.

The “excess interest rate” can be 3% and the inflation rate 7%. The fund cannot afford to grant increases in excess of 3%. In such situations, the “catch up room” available to each pensioner, which will depend on the year of retirement and the past history when the pension increases had to be limited to the inflation rates, can be used. For those with a sizable “catch up room”, the pensions could be increased by full 7%. For those with no catch room (e.g. very recent retirees), the pension increase will be limited to 3%. For those with partial catch up rooms, the increases would vary between 3% and 7%. In later years, when the “excess interest rates” exceed the inflation rates, past losses could be recovered.

As the above discussion will indicate, the maximum pension increase could vary by year of retirement (if the past “catch up room” had to be used). This is then applied to the pension that was payable in the previous year. For retirements of year (N-1), the maximum pension increase is pro-rated to the number of months for which the individual was a retiree.

Definition of “Earned Rate of Interest”

The definition of the “earned rate of interest” has changed over time. For increases from January 1^st of years up to (and including) 2000, it was equal to the yield on Canada Life funds for the previous year. For years 2001 and 2002, it was equal to the five-year moving average of the pension fund yield. Beginning with 2003, it will equal to the 15-year moving average of the pension fund yield. The yield used in computing the increases for 2006 was the average of the yields for the 15-year period 1990-2004 (the yield for 2005 would not be known at the time of computing the increases). This yield was 8.57%. It should be noted that pension fund yields make an allowance for unrealized capital gains. The detailed wording of the changes in the definitions of the “excess interest rates” is shown in the memos to pensioners from D. Barsoski (dated January 24, 2002 and January 22, 2003).

Table Showing the Indexed Pensions and the Catch Up Room

This Table of Indexed Pensions shows the following data in respect of pensions payable from January 1, 2006 for retirements that have taken place in the month of December of each year. The table is based on the factors provided by Canada Life.

· Column 4 shows the amount of current (indexed) pension corresponding to an initial pension of $100. Thus, for a member who retired in December 1992, for each $100 of the initial pension, the amount payable from January 1, 2006 would be $128. For a person retiring in December 1985, the corresponding amount will be $170.

· Column 5 shows the estimated “catch up room” available on January 1, 2006 corresponding to a current pension of $100 (i.e. payable on January 1, 2006). Thus, for the member who retired in December 1992, the “catch up room” for each $100 of current pension will be $63. For a person retiring in December 1985, it will be $109. This means that the current pensions could have been increased by these amounts if the CPI increase limitation had not been applied. This “catch up room” will be available for use in later years, if the pension fund earnings were not able to keep up with inflation (through increased yields).

For retirements taking place in months other than December, the above values can be obtained by interpolation. Columns 2 and 3 of the table show the values of the “Excess Interest Rate” and “CPI Increase Rate” applicable for the years following the year shown in Column 1.

Indexing Factors Table supplied by Canada Life, showing the factors used in the indexing calculation.

Plan Wording Excerpts re indexing from actual plan document of January 2001.

Page Last Revised

22 Feb 2006

Financial Data | Newsletters | FAQ | Links | Contact Us | Appendix