The quandary

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Poor Joanne. Only sixty, always a stay-at-home spouse, and James died in a skiing accident this past winter. Sadness now mingles with confusion, since a major decision’s been thrust upon her.

“Jim’s former employer has offered the choice of either a commuted or defined pension indexed to inflation,” she explains. “Both are generous but I am concerned about returns upon entering the market, and the volatility scares me. The lump sum being offered is $1.4 million and the pension annual payment is $61,000. I have nothing else, and there are four adult children I would like to leave them some money when I pass. You probably think this is a no-brainer. I need to make a decision asap as this indecisiveness is a little ridiculous now :)”

In fact, Joanne’s been slaving over this for a few months. In a week or two she’ll no longer have the option of commuting. “Basically,” she adds, “I’m paralyzed.”

No wonder. It’s scary. She can lock into the security of a pension payment, forget leaving money to her kids and hope the monthly is enough. Or she can take the big cheque, have it invested, and hope the returns are adequate and safe. This is life. Nothing’s perfect.

However, there are six things that I gave Joanne to think about as she ponders a decision that will profoundly affect the rest of her life. Also told her that Jim’s gift to her was extraordinary. Most people don’t have pensions at all, let alone ‘defined benefit’ ones that promise a specific amount in the future. The bulk of current corporate pensions are called ‘defined contribution’ – basically glorified group RRSPs. If you’re lucky, the employer matches your contributions, but they normally end up in a collection of crappy mutual funds with an uncertain outcome down the road.

Now, what does ‘commuted’ mean? With some defined benefit plans (certainly not all) upon retirement you can elect to start taking monthly deposits into your bank account, or get a sum equal to the annual payment times the present value factor, as determined by the Income Tax Act. This amount can be quite inflated in times like these – of modest inflation and crashed interest rates. In fact, today’s conditions almost guarantee a windfall. Like Joanne’s $1.4 million.

The majority of this money comes rolled into a tax shelter (LIRA), while some of it is handed over as taxable income. However that can be mitigated by soaking up all of the available RRSP room one might have. Then you invest the money, live off the proceeds and create your own stream of pension income. Obviously there’s market risk involved, as well as tax and estate advantages. For people who worry a lot, paying more tax, living on less while leaving no real estate to their family might be worth staying in the plan. For others, no way.

Anyway, here are the things I told Joanne to ponder.

First, she can live better by taking the commuted value and investing it. Over time (she has 30 years to live) getting an average annual return of 6% from a balanced and diversified portfolio should be routine (the last three decades gave more). That means an income of about eighty grand a year, or a 30% plump over the DB plan amount. Of course, getting 6% annualized does not mean 0.5% every month. Some years will be fat, some will suck. But over the course of a lifetime it means a better income, while the principal’s preserved.

So, second, commuting a pension means the money becomes your property. Staying in a pension plan means the money remains there. When you pass (it happens), a DB pension will sometimes flow for a period of time (at a reduced level) to a spouse, but not to kids or other family members. With a commuted pension, 100% of the principal becomes your spouse’s property or it can be passed along through your will to anybody you wish. Big benefit.

Third, you might pay less tax if you commute. Taking the monthly cheque means 100% of your payment is taxable. But if you invest, a regular portion of the non-registered amount of the portfolio can be paid as ‘return of capital’ which is not added to taxable income. Nice bonus.

Fourth, remember Stelco. The giant Canadian steel maker has thousands of retirees who all depend on their pension cheques. But when the company was sold, reorganized and generally diddled with as the world economy gyrated, many of them ended up with seriously reduced benefits. This can happen at any time, to any outfit. And the last thing you want at 78 years old is to be stiffed.

So the fifth reason to consider taking the money is you’re in control. Always. Not some unseen pension administrator you’ll never meet, speak to or influence. An insane number of pension plans across North America are underfunded these days, and governments have increasingly allowed this to occur. Why would you not want to be in charge of your own future?

And, six, if you commute and make use of your TFSA to shelter a significant and growing chunk of the pension money, you can draw income without being bumped into a higher tax bracket. That means more of the CPP or OAS payments stays in your own hands, not Justin’s.

Now, commuting ain’t for everyone. You have to understand the pros and cons, find a trusty person to manage things and ignore short-term market volatility (which means never reading this pathetic blog again). Some people want automatic pilot. Others want the stick.

I know what I’d do. Will tell you what J decides.

Guy thing

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More mortgage changes to parse, but first let’s discuss poor Mark – the millionaire who thinks he can’t afford a house in Calgary.

“I don’t understand why the Calgary housing market is so sticky on the way down,” he says. “There are thousands of layoffs every month and more to come, yet a newish 2,800 sq ft family home with 20 square feet of lawn in the suburbs is still a million bucks. My wife and I (33 & 32) sold our home in December 2014 when oil started its crash and have been renting ever since. We’re now expecting twins (!) and my wife is dead set on buying a home. She has been very patient over the last year and a half, but these babies are on their way! I thought we could wait out the market but it’s a slow grind down. Where’s the tipping point? Our net worth is $1mm and we earn combined gross income of $330k annually.”

Well, Mark, blame human nature, severance packages and an unexpected bounce in oil to the $45 level. Real estate’s always sticky, and the higher average prices head, the stickier it gets. It’s now a part of our culture that every family must make money on every house sale, or they’ve somehow been cheated. So instead of going to market with a price that’ll attract buyers in a realistic amount of time, sellers would rather sit for months. And months. And months.

The oil thing has warped a few minds, too. Although prices are low enough to keep Cowtown frozen, the 60% recovery since the winter has rekindled hope the worst is passed. It isn’t. Meanwhile long severance packages have kept a lot of people in situ, figuring by the time they sell, pay commission, move, relocate and try to find another job, the troubles will be behind them.

And don’t forget the cowboy gene. Real men don’t lose money. Houses are the new equities, and everybody’s an expert. Selling a property for less than you paid is a fail, especially when it comes on top of losing your six-figure job as an O&G exec.

Anyway, Mark, you obviously have options. First, don’t buy now because prices (sticky as they may be) are unlikely to stay at current levels. The babies won’t know if you own or rent for at least ten more years, so what’s the rush? But if you have to bow to marital pressure, don’t be fooled by asking prices. Remember – this is a guy thing. You’re in a market where qualified purchasers with firm offers get to call the shots. There are no multiple offers in Calgary these days. No bidding wars. No bully buyers. And that segment of the market above a million is where the biggest bargains are being found.

Finally, remember you can get a five-year, fixed-rate mortgage for 2.5%. If you borrowed $800,000 the cost would be $3,500 (probably close to your rent), and because of the cheapo rate about $126,500 in principal would be repaid over the term, with $90,000 going to interest. That means if you committed $200,000 (20%) to the house and kept the rest invested, over five years at an achievable 6%, that eight hundred would end up being $1.07 million.

Borrow at 2.5% and invest at 6%. Duh. And is a Calgary house going to appreciate in price by 6% a year over the next half decade? Seriously?

So, Mark, if you lose you can still win. Sort of.

Now speaking of mortgages, the feds are diddling again and it means higher rates later this year. On Friday the regulator (OFSI) told the banks they’ll soon require greater capital reserves, and here’s why: “These updates will ensure that capital requirements remain prudent in periods where house prices are high relative to household income and/or house prices are increasing rapidly in nominal terms.”

Yep. Blame Vancouver and the GTA. Ottawa is worried once real estate markets start to sell off (and they will) banks could be impacted, since they have billions and billions in outstanding home loans. This new rule will require them to put aside more cash to deal with problem loans in the overvalued markets.

This might add less than a quarter point to the cost of a mortgage, but it doesn’t come in isolation. By the time the rule change applies (November) it’s expected the US Fed will have increased its benchmark rate once or twice, and bond yields (some have already doubled) will rise taking mortgages with them. Especially the fixed five.

You might find this warning from OSFI interesting: “Potential losses may become more severe during extended periods of rapid price appreciation and/or periods where house prices are unusually high relative to household incomes — since the value of the collateral underpinning these loans is likely to be less certain in those circumstances.”

It means people taking out mortgages in, say, Halifax or Montreal at a higher rate will be subsidizing those delusional tools borrowing to buy in YVR or the Kingdom of 416. But what else is new?

Good luck, Mark. Two babies, an iffy real estate purchase and a move. Enjoy the stress.