The pension conundrum

  By Guest Blogger Sinan Terzioglu

Whether or not to commute a pension is far from an easy decision.  Many prefer the guaranteed income stream for life instead of commuting and taking on the responsibility and risk of hiring an advisor or managing the assets on their own.  While everyone’s goals and circumstances are different it’s definitely worth considering and understanding whether commuting a pension could make sense for you and your family.

Some advantages to commuting:

  • Flexibility. Instead of receiving a fixed amount starting at a certain age, you gain the flexibility to withdraw more or less from a portfolio as well as having access to as much of the funds as required, whenever you want.
  • Control. You’ll never meet the manager of an institutional pension fund whereas you have the ability to choose or change who manages your commuted pension, as well as regularly speak with them to ensure the portfolio’s being managed in the most efficient way to meet your goals.
  • Potentially less tax. Defined pension payments are fully taxed as income, whereas when withdrawing from an investment portfolio one has the ability to take funds in a much more tax-efficient way, plus to defer taxes.
  • More for your loved ones. If you pass away there may be survivor benefits for your spouse for a period of a time but more they’ll be reduced. Likely there will be no benefits to children or an estate when the pensioner passes.
  • The chance to do better. By commuting a pension and investing in a balanced and diversified portfolio that includes government and corporate bonds, preferred shares, alternative assets, REITs and growth assets that are geographically diversified one is essentially investing just like a pension fund manager does but with more upside because of compound growth.

As life expectancies increase and health care costs continually rise it’s more important than ever to ensure one will have enough income to last several decades.  Government pensions do not come close to covering most people’s needs and if you’re one of the lucky few to have a defined benefit pension plan it is critical to understand the health of your employer’s pension plan and whether there are medical benefits and if the benefits are indexed to inflation.

Many Canadian corporate pension plans are underfunded and regulations do not require them to be fully funded.  Unfortunately for retirees of Sears Canada this lack of regulatory enforcement cost them, as they had their pensions slashed by 30% following the bankruptcy and closure of the retailer. So 18,000 retirees who paid into the plan for decades are now living on much less than they expected and some have been forced to return to the work force in their 60s and 70s. Defined benefit pension plans of corporations are far from guaranteed.

When commuting a pension a portion is transferred tax-free into a LIRA (Locked-In Retirement Account) with the balance gets paid out in cash.  If you have available RRSP contribution room you can take advantage of that, otherwise the cash portion comes into your income for the year.  Many struggle with this as it results in a large tax bill, but this money would never have landed in one’s pocket if the pension were not commuted, so it’s important to understand that when considering whether or not to commute your pension.  Also every monthly payment would be taxable, had you stayed in the plan.

Commuted pension, double the retirement income

Here is a hypothetical example. Let’s suppose a 35-year-old switches jobs and has the ability to commute her DB pension.  If she leaves it in place she’d receive $3,000 a month ($36,000 annually) pre-tax, not indexed to inflation starting at the age of 60.  If she commutes, $200,000 would go into a LIRA (no tax) and $150,000 would be paid in cash (taxable as income minus RRSP room).  She has $50,000 in available contribution room so she maximizes that and the balance of $100,000 is brought into income for that year, netting her $50,000 after tax.  She invests the commuted value in a balanced and diversified portfolio of $300,000 ($200,000 LIRA, $50,000 RRSP and $50,000 non-registered).  Assuming she earns a 6% annual rate of return that sum would grow to $1,300,000 in 25 years.

At age 60 she could comfortably withdraw $78,000 a year or $6,500 per month, pre-tax, without depleting the capital.  If she contributes to a TFSA or any other accounts over the balance of her career she may require less income from her commuted pension, allowing it to continue growing and deferring taxes.  The non-registered portion alone could potentially continue growing for the balance of her life and the compounded growth plus any other assets could be left to her family and estate instead of a pension plan.

So commuting a pension is certainly not a one-size-fits-all decision, and not all pensions are the same.  Some have very good benefits and are indexed to inflation so the decision is not always clear. There are many considerations. They are not all financial.  We all have different risk tolerances and circumstances.

A good starting point is to think about your long term goals and what you value most.  For me personally, I don’t like the thought of contributing to a savings plan for most of my career and not being able to have control of it or access to it as well as the ability to leave it behind to my family after I pass.

Sinan Terzioglu, CFA, CIM, is a financial advisor with Turner Investments, Private Client Group, Raymond James Ltd.  He served as vice-president of RBC Capital markets in New York City and VP with Credit Suisse in Toronto.