Should I keep or commute my company pension plan?
In recent months, we’ve had numerous enquiries from individuals who are retiring or leaving their employment and wondering if they should keep or commute their defined benefit corporate pension plan.
In this post, we’ll outline what it means to commute a pension and describe a real-life client situation that exemplifies the pros and cons of both strategies.
What does it mean to commute your pension?
Broadly speaking, commuting a pension means taking a lump sum today versus receiving a stream of payments from the corporation starting in retirement.
Why would an employer provide the option? A defined benefit pension plan is an ongoing liability to the sponsoring company. If the investment performance of the pension under performs, or you live longer than expected, the plan can become underfunded, which could be expensive for the company.
If the pension is commuted, the company no longer has the obligation and the risk is transferred to the individual. There is no longer a guaranteed stream of income and the obligation for ensuring there is enough money for retirement is now in your hands.
In determining whether you should keep or commute your company pension plan, there are a host of financial and personal factors to consider. There is no one size fits all.
Let’s consider Peter and Susanne*. When we met them in 2003, both were employed by a large company in Alberta, with a good pension plan. They had both just turned 50 and, having worked since high school, both were eligible to retire early. They had a home, with a $300,000 mortgage on it and some savings. Their goals were to retire, purchase a second home and spend time with their children and grandchildren. Together, Peter and Susanne were eligible for a combined annual pension of $120,000 ($60,000 each). However, if they commuted the pension they would receive a lump sum of approximately $1.8 million after tax, divided between their LIRA, RRSP and cash accounts.
First, what does the math say?
When we worked out the math, we determined the pension income represented a return of about 6.7% on the value of the plan. What’s more, the pension income would be guaranteed, and they wouldn’t have to worry about market volatility.
By comparison, an investment portfolio with a moderate amount of risk would likely generate around 7-8% per year.** On the surface, why would Peter and Susanne want to take on the risk that the portfolio may not generate that return?
What are your goals for retirement?
Well, Peter and Susanne had other goals for retirement. They wanted to pay down the mortgage on their principal residence, they wanted to buy a vacation property and they wanted to help their children financially. An income of $120,000 per year would allow them to live quite comfortably, but these other goals would eat into that income significantly.
Are you concerned about being able to pass on assets to your family?
Another consideration was estate planning. Peter and Susanne wanted to ensure that each of them would be taken care of if the other passed away prematurely.
Our analysis helped them understand that the pension would have a spousal death benefit of about 50%. So, if one of them died, the annual pension income would be reduced to $90,000 per year. If they both died, there would be no further pension income or asset to pass on to their children and grandchildren.
On the other hand, if they commuted their pension, the inherited portfolio would continue to generate approximately $120,000 to $140,000 per year ** if one of them passed away. If they both died, there would be a sizable estate to pass on to their children and grandchildren.
What is your tolerance for risk and market volatility if you commute the pension?
After considering their options, Peter and Susanne decided to commute their pension. They told us a principal factor in their decision was their confidence that Newport’s investment approach could deliver the returns they expected, with less risk and volatility. Our diverse investment universe of 12 asset classes and long-term track record reduced some of the ‘market worry’ they might have otherwise experienced. If you are uncomfortable with the responsibility of managing your assets, or placing them with a professional manager, then your better option may be to keep the pension with your employer.
After commuting the pension, Peter and Susanne paid off the mortgage and then opened a line of credit for the same amount, changing the mortgage from “bad debt” to “good debt” – debt which is tax effective – enabling them to write off the interest against their taxes.
They spent approximately $200,000 on a second property, bought a few toys and made a small gift to each of their children. They were left with a portfolio of ~$1.6 million, which would generate an annual income between $110,000 to $130,000. Based on a review of their spending habits, we helped them determine this was an income that they could safely live on, without touching the principal. However, should the need arise, they would have the flexibility to access their capital, whereas the pension wouldn’t have allowed them to do so.
Allow for the unexpected
Tragically, in 2008, Peter passed away after a brief illness. Weeks before he died, he called me to say that he felt so much better knowing that Susanne would be taken care of financially for the rest of her life and that her lifestyle would not have to change.
After Peter died, Susanne sought to bring as much stability to her life as possible, so she eliminated all debt, reducing the portfolio to about $1.35 million.
Today, the portfolio is worth approximately $1.4 million. Susanne is debt free and continues to travel between her home and vacation property and spends time with her children and grandchildren.
Obtain an analysis of the financial, personal, emotional and behavioral factors
The decision about what to do with your pension plan when you leave your employ is not straight forward, nor is it easy. However, a clear-eyed numerical analysis combined with a careful review of your personal objectives, behavioral and emotional factors, will help to ensure you make the right decision for you and your family.
If you are faced with a decision about either a defined benefit or defined contribution pension plan, feel free to get in touch with us for help in weighing the factors.
*Names and other characteristics have been changed.
** Returns are not guaranteed nor indicative of future performance