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.