Commuted Value vs Indexed Pension

I read an article awhile back that basically said you could not safely earn enough by taking a commuted value pension as you could with a traditional indexed one. My health has not been the greatest and I like the idea of leaving 100% to my spouse and down the road, an estate to the kids. I have an opportunity to receive a substantial amount of money and currently have a healthy mutual fund portfolio. Would I be better off to consult a fee for service advisor and does anyone think it is possible to be just as successful going the commuted route? Any advice would be greatly appreciated as I do not have a lot of time before I must inform my company of my decision?

Confused .. I am surpised at the time element. My personal experience has been that one has 6 months to give them a decision. You need time to reflect so do not allow yourself to be rushed into it. I am sure they would be flexible on the time element, unless you have been sitting on it and the panic to meet their deadline has set in.

I am by no stretch of the imagination an expert on these matters, but I figure you should look at the present or commuted value of your pension and figure what rate it needs to earn so as to give you the same payout for life, effective your normal retirement date (65 I presume), as your ex-employer now guarantees you will get if you were to leave the cash with them.

If you do not expect you will live till a ripe old age, then you should figure how much your spouse would get in the event of your demise, again as compared to taking the money up front and investing it under your own control.

If you are talking big bucks and your health is a concern, you would be bonkers NOT to spend the money for good professional advice (It does not come cheap, nothing worthwhile does).

If you elect the pension then you are stuck with it, for life (yours, or your spouse, if you go first). It is almost like buying a life annuity. There is no going back.

Consult a financial advisor whom you can trust.

If you take the money, up front, you at least have control over it.

I trust some FA's will post their advice, because in this complex field, I am a novice, and am not ashamed to admit it!!

Good luck. Looks like you will need it!!

This is another of those topics that generated a fairly extensive discussion a year ago. Alas, another good thread lost.

I agree with Mike-1's advice, but will add a few personal comments as I went through this a couple of years ago (which doesn't make me any kind of expert, however). First, do not forget to weigh the value of any benefits which come with the pension. I had the chance to talk with someone who manages pension funds and his comment was that too few people take this sufficiently into account. Indexing and extended health benefits seem to be the main issues. But things can look very different if the spouse also is pensionable. Age is another factor - how long will your money need to last if you take it and run?

About 140 people retired when I did (an early deal) and only about 7% of them took the commutation. I know a couple of them who did so because their own health was threatened and it appeared their spouse would be much better off with the commutation than with survivor's pension. One did it because his wife was also pensionable (under the same plan) and he could draw on her plan for the desirable benefits (but her health is now doubtful, his restored, and things look rather different at this point). Another did this because his situation was such that he wouldn't need his pension money for fifteen years anyway. One who took the pension did so because he was going to need fairly long-term health care and the projected cost of providing the equivalent to the company benefits was, in his opinion, prohibitive. He also abandoned his plans for retirement to his place on Saltspring Island because "the plan" limited out-of-province benefits to $40K lifetime. Me? I'm just cautious - how did I know the bull would continue to run so hard!

I mention these things just to point out that personal circumstances are very variable and there is no substitute for very personal advice. But even with the best advice, it's still a gamble in the final analysis. Make a decision you can live with and don't look back.

Mike & Ron Thanks for your replies. The time issue is too complicated to discuss here but unfortunately it is a reality. I most certainly will discuss this with professionals and I remember the thread which I can no longer recover. I'm confused as to the different FA approaches and could use some advice ie: are there firms which specialize in these situations as opposed to someone simply selling funds. With this kind of decision and the money (700K?) involved I don't feel remotely qualified- it's obviously not the same as playing with a fund portfolio and my timeline has become extremely critical. I remember Warren talking about different approaches- is he still out there? Also, the whole question of whether the commuted approach can equal the safety and benefits of the standard pension (which in my case will be reduced, but still @60%) is something I have to settle. If I did go commuted, believe me, preservation of capital would be my #1 priority. Having no knowledge of other approaches than mutual funds, I definately need advice and the fair city I live in is not blessed with a lot of choices....

Advice not only welcome but very appreciated!

Confused,

your health (life expectancy) appears to tip the scales in favour of the commutation. As you already have a "healthy MF portfolio", you should also consider the investment and tax equations in your decision making.

Actuarial calculations for indexed pensions are designed to be consistent with the assumption that $ invested today will earn long-term Canada bond rates plus 0.5% for 15 years and will earn 6% thereafter. So if the commuted value is invested at higher expected rates of return (i.e. some allocation to equity holdings) inside the RRSP then commutation is "best" from the investment perspective.

If the commuted value option is elected, tax sheltered compounding works its "magic" until age 69 inside the RRSP until legislated minimum withdrawals are mandated inside a LIF commencing in your 70th year. As wealth transfer appears to be one of your prime objectives, commutation may offer a strong tax advantage.

Confused .. having spent ages (or so it seems) in the life insurance business, one name springs to mind.

I would not normally recommend firms or put in plugs for others, but I know that William Mercer and associates, a firm of consulting actuaries, who have a pan-canadian presence, are well reputed and are used by many life firms to advise their own internal actuaries.

Try them. If they feel they can not handle it, they might be able to recommned somebody competent. What with the downsizing in the life business, I imagine there are more than a few actuaries who now turn to free lance consulting.

None of these professionals come chaep, but 700K is nothing to sneeze at either.

Hi Confused-

The following link will take you to another thread where I posted a couple of other links to articles discussing commuted value.

Confused: It would be fairly easy for a consulting actuary to evaluate and explain your pension plan. The actuarial firm mentioned -- William M. Mercer -- is a very good but very large firm and more used to dealing with corporate clients. There are many smaller ones all over Canada that might be cheaper and easier to access.

There are also retired actuaries and actuarial science professors with small-scale consulting practices.

The Canadian Institute of Actuaries can refer you to actuaries in your area. CIA is their governing body and every actuary belongs. CIA's website is www.actuaries.ca.

confused, go to Mercer and have them lay out the programme in your format.

This is exactly what i did and, for me, the commuted payout was better. Iam nervous about any monies that reduce after my death and leave no estate.

health Care??

It continues, I am not sure what the problem is. talk to their actuaries, it is not expensive and it is worth it.

Confused,

Here are some general comments , specifically focussing on defined benefit plans:

Many pension funds are confined by law to invest in "safe" investment vehicles. In Ontario, this means FIXED and such.

You will recall that the entire pension world went crazy in the 80's, when the pension plans accummulated more money than they required to maintain their obligations for outstanding pension members. The reason that this big fuss occurred was the explosion of interest rates in 81 and 82 era. This prompted Conrad Black and other companies to Draw down the funds, and ended up in court.

I do not recall any Pension surpluses being an issue in any of the years since, with all the high equity growth occurring. . Could this be that Pension funds are still not investing significantly in equities. (with Ontario Teachers being a notable exception ) If they had been investing in equities in the last 4-5 years, with all the downsizing (fewer employees remaining in the pool), there should be ENORMOUS surpluses.

So, here are a few general thoughts:

Because DEFINED BENEFIT pension plans are based on legal contracts between employees and the Plan, the Government regulators require that benefit amounts be based on VERY Conservative actuariial assumptions - in order to ensure that Pension Plans never become insolvent - projected payouts must be provided for comfortably So they use Investment return rate assuptions , say in the 4% range.

Defined benefit plans always pay out less than they earn, - for the same reason - to ensure there is enough left for those who come.LATER.

On the other hand, the commutation option takes you into private RRSP's and other options. This switches the legal responsibility away from the Pension Plan to YOU - so no prescribed investment regulations are required. , - because you are the investor - same as any other RRSP. BUT - that does open the door for YOU TO DECIDE how much FIXED and how EQUITY you want to ianvest in. Because your hands are not tied !

The question of your age is an entirely separate variable:

If you have a family history of longevity, inside the Pension Plan, you would beat many of the other participants, BUT YOU WOULD NEVER DRAW MORE THAN THE PLAN EARNS FOR YOU, because the Actuarial Estimates will make sure of that.

If you have a family history of short life, again the PLAN WINS, even if they pay you some kind of death benefit, because the Actuarial practices protect the plan from paying out too much.

Now, applying the issue of longevity to the private option,: Lets operate on the assumption that you do not EVER want to touch the 700K principal.

The key is :What do we invest in relative to support your desired annual draw.

I doubt that you will need more than 70K to live on per year. At that rate, you can expect to not EVER exhause the fund or even to impair the capital; a number of managed funds have demonstrated that they can outproduce the 10% that you draw annually.

Having said all this, we need to get down to specifics -there are other issues that have to be addressed - which may override all else

My observations are partly "top Down" having been an auditor of a Life co for a number of years.

Ontario FA

Papajohn's discussion of defined-benefit pension plans is full of misconceptions.

1. The asset mix and performance of a DB pension fund's portfolio is irrelevant to the plan member. That's because DB credits are nothing but a promise made by the employer and in some cases the union. That promise is that there will be a pre-set retirement benefit based on a pre-set formula. That formula is usually some form of average earnings multiplied by years of service multipled by an "accrual rate" of no more than 2%.

The key point to understand is that the employer is on the hook if the fund does not do well enough to fund that promise. The employer carries the market risk, not the employee.

2. It has been many years since pension plans were confined to "safe" fixed-income investments. Pension funds are akin to balanced funds. Each pension fund manager knows the average return needed to meet the plan's projected payouts -- the promise mentioned above. The plan is then managed to meet that target.

Each year the pension industry magazine, Benefits Canada (www.benefitscanada.com), surveys the 100 largest plans. For 1997 it found an average 54-36% equity/fixed income split with the remaining 10% in venture capital, direct real estate and cash. The 54% equities weighting was 34% Canadian and 19.5% foreign.

3. Accumulating surpluses have been a substantial issue in recent years but the pension industry draws little attention from the media and financial advisors. There has been considerable court and regulatory action over the issue of whether the surplus belongs to the members or to the employer. Unions argue that pensions are really deferred wages so any surplus belongs to the members and should be used to enhance benefits. Employers argue that they should benefit from any surplus since they have to make up any shortfall. Court and pension commission decisions have varied depending on the circumstances. Just this week the Ontario govt and its teachers unions agreed to use pension surplus to fund early retirement for 18,200 teachers.

4. Papajohn states that due to concerns about potential insolvency govt regulators require pension managers to use conservative actuarial assumptions such as a 4% investment return.

First, that would be a 4% real return, which is actually quite reasonable based on long-running historical data. Second, the assumptions are not based on insolvency but rather income tax rules aimed at controlling govt's cost for the pension tax shelter. Ottawa controls its revenue loss on RRSPs by imposing a set limit -- eg., $13,500. DB plans work differently; there is no set limit like that. Rather, govt limits the amount of pension that can be paid to $1,722.22 per year of service and allows employers to contribute, on a tax-deductible basis, whatever is needed to fund that promise....but the Finance Dept sets conservative assumptions that must be used in projecting that liability out into the future.

5. Papjohn states that no matter how long you live, you would never draw more than the plan earns for you. Balderdash. Using unisex mortality tables, pension actuaries generally assume you'll live to 83. Those assumptions are also contolled by tax rules. Those who live very long lives are subsidized by those who die earlier. The calculation that produced the $700K commuted value was based on the plan's assumptions for longevity, investment return and inflation -- not on performance to date.

6. Papajohn suggests that a $700K transfer value will fund a pension of $70K a year. He ignores the fact that this is an indexed pension and the inflation indexing was a key part of the commutation calculation. Assuming 3% inflation and a rather aggressive 10% return, the $700K would be exhausted in just over 17 years.

A fully-indexed DB pension plan offers the greatest degree of security in that you know the pension in advance and are immunized against market and inflation risk. A regular RRSP offers the greatest flexibility in both investment management and estate planning, but you then carry full market and inflation risk. The locked-in RRSP plan -- where this commuted value would have to go -- is a hybrid. It carries the flexibility, market and inflation risk of an RRSP until age-80 at which time it must be converted to an annuity that promises lifelong income. Alberta and Saskatchewan have a variation called an LRIF which provides RRSP-like flexibility past 80.

This is an issue I see almost daily. The misconceptions and misinformation around CV that is provided to members of a DB plan (some of it from their financial advisors) is incredible. Unfortunately , I see people making decision on this misinformation all the time.

One of my personal favorites is that the pension plan does not want you to take a CV because they will lose money. This really isn't the case. (Given the size of some of the DB plans these days a CV of even $700 thousand is lost in rounding).

Bruce your explaniation is clear and precise and outlines the situation perfectly.

The decision of whether or not take a CV requires seroius consideration. Once you decide to take it - you cannot revisit your decision. I would encourage you to get professional advice.

Bruce,

excellent posting! I have some inquiries with your item 6.

Are you saying that the Confused does not need to withdraw the "locked-in" commuted value prior to mandatory annuitization at age 80? I thought that it would be required to convert the RRSP to a LIF at age 69, with legislated minimum to maximum withdrawals commencing in your 70th year, and then buy an annuity at age 80. Or is the age 80 situation unique to Alta and Sask?

Papajohn's systematic withdrawal plan (SWP) is not so easily dismissed. The commuted value option (SWP or annuitize at any time in any combination e.g. back to back annuity) offers more flexibility but "real" return risk in exchange for the "known" actuarially computed pension income.

BTW, what sort of general questions should Confused put to the actuarial advisor to get a handle on his/her situation?

Looking forward to your reply,

Most excellent posts from Bruce Cohen and Laura, in my opinion. Couldn't say it better. This thread is a keeper, as this is one of the most misunderstooed aspects of retirement planning.

Wow! I would like to thank all of the contributors for their input.

It most seriously IS an important issue and I will have to come to a decision within two months.

My current train of thought is to couple my fund portfolio and my commuted value and go with a "fee for service" investment firm that charges 1% of the total value and makes the actual investment decisions after my individual situation has been evaluated and discussed.

I feel that at this point, the numbers and the time and responsibility, show this to be the most prudent option.

Leaving the security of a "sure thing" is not being taken lightly; perhaps, the easiest decision would simply be to take the normal pension and "get on with it". But the alternative is more than intriguing- how do you balance the differences between the options?

Most of my friends would consider me to be reckless and crazy to give up the pension and go commuted. I guess time will tell. I still think that the estate factor is most important and will I be defeated by market conditions and inflation? Not being anything of an Economist, I really don't know- but then, there is a risk ant time you cross the street- let alone trust the gov't!

Thanx again for the input!

Michael:

Re: my point-6: I didn't bother applying the minimum withdrawal rate because the starting assumption was a 10% drawdown and the minimum rate doesn't reach 10% until age-85.

As you correctly noted, a locked-in RRSP (technically called a LIRA) must be converted to a Life Income Fund (LIF) at the end of the year in which you turn 69. LIFs are like RRIFs except that:

1. In addition to a minimum annual withdrawal, there is a maximum annual withdrawl limit. This was designed to ensure there is money at age-80 to buy an annuity for lifelong income.

2. At age-80 the LIF must be annuitized. The idea is that the money originally came from a registered pension plan where the employer promised lifetime income, and the pension regulators wanted to ensure that the money is used for that purpose. Several years ago Alberta developed the LRIF as an alternative for those who don't want annuities. Saskatchewan subsequently adopted it. I believe Manitoba might be considering it, but my understanding is that pension regulators elsewhere have been cool to the idea. An LRIF is really just an extended LIF.

The problems in comparing a SWP to a fully-indexed pension plan relate to inflation risk, market risk and longevity risk. Purchase of an annuity addresses the longevity risk and might even address the inflation risk if you could get a good quote but what's the functional difference between an annuity and a pension plan. They're equally inflexible and have limited estate value. Note that "prescribed" annuities cannot be purchased with registered funds.

Perhaps the biggest concern in discussing pension commutation is market risk. Most of today's financial advisors and nearly all of today's investors have not experienced any climate other than history's longest running bull market. Their experience base also consists of a sustained fall in the Canadian dollar which has substantially increased returns on foreign investments. More significantly, investment returns have not yet really reflected the new -- more historically normal -- level of low inflation. For example, historically the stock market has delivered a real return of approximately 6%. If inflation remains in the 2-3% range, broad stock returns should reasonably decline to the 8% level -- unless we truly are in a new era for valuations. With an indexed DB pension plan, you know what you will get. With a SWP, you don't. You may well do better than with the DB plan but what are the possible outcomes if you do worse?

Some questions for an actuary: 1. Verify the present value of my credits. 2. Considering my gender, age and health, what's a reasonable assumption for longevity 3. If I commute, what average annual investment return do I need to exceed the pension payment by enough to justify the inflation, market and longevity risk i've taken on 4. Based on multi-decade historical data, what are reasonable return assumptions for stocks, bonds and cash 5. Explain the age-80 annuitization rules for my LIF. Explain the interest rate risk I'll incur. (I should explain this. Annuity pricing is based on interest rates at the time of purchase. When you go into a LIRA/LIF you are really setting aside a large chunk of money that will be annuitized at some point in the future. If interest rates are high then, you can do quite well going forward; just consider the case of someone who annuitized in the mid-80s when rates were 10-12% or more. But if interest rates are low, you're then forced to lock in lifetime income at a low level. The point is that nobody knows where interest rates will be in 10, 15 or 20 years) 6. Does the pension plan include health or dental benefits at a subsidized cost?

Bruce, thank you very much for your time and erudite analysis. Hopefully this thread will enjoy longevity and not be "trashed" in cyberspace. (Repeating myself), your consideration and skill are much appreciated in this forum.

Bruce! Thank you for the analysis. I think that this is one of those decisions where only time will tell.

What is the worst case scenario? You spend all of the capital before you die and have nothing left, or you spend it prematurely and become a burden to somebody somewhere?

If someone can convince me that the pension (it does not include benefits and is indexed to 8%) is most definately better than commuted, then that is the course I would follow. It is not a "I'm in control of the money" proposition. This is not an ego trip.

As I understand it, roughly two thirds is placed in a locked-in RRSP and the remainder is taxed 30% immediately, with the gov't looking for their remaining 20% From the RRSP, you must withdraw a calculated amount monthly. Is this scenario too dangerous?

I am looking at firms such as McLean-Budden, PH&N, Bissett, Conner-Clarke, etc. Health is a definite concern as that is the reason I had to leave the workplace to begin with- with one of these companies managing things at 1% will the economy go so sour that this course of action be a mistake? If such is the case then living on a regular pension and watching my mutual fund portfolio going belly-up doesn't seem to be too enjoyable either?

The excess amount that is transferred to an RRSP must be withdrawn immediately (by end of the month is which the transfer is made) or else the Revenue Canada penalty tax on excess RRSP contributions will kick in.

Wherever you transfer your funds the financial institution is required to issue you a tax receipt for the amount above the ITA transfer limit.

When you withdraw these funds from your RRSP, tax will also be withheld at source and a T4RSP will be issued to you at the end of the year.

To avoid double taxation there is a special form that is completed when filing your tax return for the year of the transfer. Completion of this form ensures that you are only taxed on the excess amount once.

Confused,

If you live in the Toronto area I suggest you contact Barry McNicol at Fortune Financial. He is a FP who handles these types of cases exclusively and can do all sorts of projections for you. He puts on regular seminars in the Toronto Area and will give you a free consultation. I went to one of his seminars and he is very professional and personalbe.

Good Luck