Help a client choose whether to commute his pension

THE EXPERT

Kathy Clough, CIM, CFP, R.F.P., Portfolio Manager, PWL Capital Ltd., Toronto

THE CLIENT

Anil, 61, a married and recently laid-off senior bank employee who must choose whether or not to commute an indexed, defined-benefit pension plan. He worked for the bank for 25 years.

THE PROBLEM

If he commutes the pension, Anil would get a large lump sum that would go into a locked-in retirement account (LIRA) if he holds off on withdrawing the money until later, or a life income fund (LIF) if he starts withdrawing now. But taking the pension is a turnkey, immediate solution.

THE SOLUTION

Anil is happy to start retirement now. His wife, Meena, is a teacher and also has an attractive pension. She’s still working, but the couple is supporting two daughters through master’s degrees, so Anil needs to draw income right away.

• -2.6% Median funded status of 47 largest Canadian company defined-benefit pension plans (as % of shareholders’ equity)
• 91.0% Median funding ratio of 47 largest Canadian company DB pension plans
• $27.8 billion off-balance sheet actuarial losses to DB plans under Canadian GAAP* prior to implementation of IFRS†

Source: Wiedman and Henderson, “The transition to IFRS: Erasing pension losses.” *Generally Accepted Accounting Principles. †International Financial Reporting Standards.

Anil has a minor heart murmur, and his wife’s benefits cover 70% of his medical expenses. He’d like to claim the rest under the plan that would come with his pension. Plus, one daughter has a thyroid condition that requires daily medication. As a student under age 26, she’s covered under both parents’ plans.

Anil wants income right away, so his choice is between a LIF and the pension. The LIF would let him direct his own investments and roll some funds to a regular RRSP. He could also modify withdrawal amounts to manage around government benefits that have clawbacks, such as OAS.

Both Anil and Meena’s employers took pension contributions off their paycheques, so their investment experience is limited to purchasing real estate—their family home and a cottage. They’re used to being able to see and feel assets, and haven’t yet directly experienced the roller coaster of the markets.

To show Anil what would happen if he chose the LIF, “I’d calculate the investment return that would be required in order to meet or better the pension,” she says. “And I’d explain what kind of asset mix we’d have to put in place to get that return.”

Canadian Company pensions in deficit

Canada’s largest company pension plans have, in total, a $14.7-billion shortfall.

A Richard Ivey School of Business analysis of the 47 Canadian companies with the largest pension liabilities showed 40 had fewer pension assets than liabilities as of the end of fiscal 2010. The 47 companies’ aggregate pension liabilities of more than $150 billion exceeded total pension assets of about $136 billion.

“Air Canada has the largest pension deficit with $2.1 billion, followed by Nortel Networks, Bombardier Inc, and BCE Inc., each with deficits of approximately $1.5 billion,” says the report. “Only seven companies in our sample report pension surpluses, which range to a maximum of $346 million for the Bank of Montreal.”

Authors Christine Wiedman and Darren Henderson found declining interest rates in 2010 negatively affected pension plan health. “For example, Air Canada disclosed that for every 0.25 percent decrease in the discount rate, pension liabilities increase by $411 million.”

The news isn’t all bad. “Forty-five of 47 firms in our sample reported returns on pension plan assets that exceeded longrun expectations,” the authors say. “The median actual return was close to 10%, compared to a median expected long-run return of 7%.”

Anil would need to earn 9%, which means a heavy equity weight. He’s the wrong candidate for that approach because he’d be terrified if his LIF fell in value.

His level of discomfort makes the decision easy: take the pension, and the medical benefits and certainty that come with it.

Estate-planning considerations

If Anil dies prematurely, he’s chosen to have his pension drop to 60% and be paid to Meena until she dies. (After Meena dies, the pension will stop.) A LIF lets her roll the funds into her RRSP with no tax consequences. Plus, after both parents have died, any remaining after-tax funds in the LIF go to the daughters.

Anil and Meena prefer to support their daughters’ educations instead of leaving a large inheritance. So the potential estate planning opportunity of the LIF isn’t a driving factor in the decision.

What if?

If Anil were only a few years into his career, in a non-indexed DB pension plan, Clough would have been more likely to recommend he commute the pension.

“The younger the client, with fewer years of service, the less impact it’s going to have on the overall financial plan,” she says. “Chances are better that the client will end up with a bigger [amount with which] to generate pension income.”

What if?

If the pension wasn’t indexed, Anil would risk his purchasing power declining as the years went on. The commuted value would also be lower to reflect the lack of indexing.

ADVISOR DIFFICULTY LEVEL 7/10

The advisor has to understand the assumptions made in calculating the commuted value and be able to run comparisons between the LIRA and the pension.

CLIENT ACCEPTANCE LEVEL 8/10

If the advisor properly explains all the moving parts.

“If they take the commuted value, handle their own investing, and start drawing it right away, they’re taking a fairly substantial risk,” says Clough. If markets perform poorly, Anil’s LIF income would drop lower than what he would’ve gotten from the pension.

Warning

Since commuting the pension will result in a large lump sum that’s ripe for investing—with the potential for the advisor to earn sizable fees and commissions—“it is absolutely imperative to declare the potential conflict of interest,” says clough.

Major Canadian banks are solvent and stable, but there’s always the risk a company’s pension may be so underfunded that it doesn’t get paid out. So check the corporation’s financial statements, as well as those of the pension plan, to See if the plan has enough to pay out.

Melissa Shin

Melissa is the editorial director of Advisor.ca and leads Newcom Media Inc.’s group of financial publications. She has been with the team since 2011 and been recognized by PMAC and CFA Society Toronto for her reporting. Reach her at mshin@newcom.ca. You may also call or text 416-847-8038 to provide a confidential tip.