Commute this pension or not?

Client profile

Georgi Balev*, 50, just got laid off. He was a senior manager at a major engineering firm in Ottawa, Ont., where he had worked for the past 26 years. His total annual compensation, including bonus, was about $300,000. His dilemma: Does he wait until age 65 to start drawing his defined-benefit pension, or does he take the commuted value now?

The situation

It wasn’t so long ago that Georgi wouldn’t have needed to think twice about his options, notes Carol Bezaire, vice-president, Tax, Estate and Strategic Philanthropy, at Mackenzie Investments. Anyone in Georgi’s shoes would almost always have been better off by taking the monthly pension rather than the commuted value, she notes. Now, as difficult economic and market conditions challenge the funded status of once-stable pensions, “you definitely want to take a look, case by case, and ask which option is better for the client.”

The experts

• 

  Carol Bezaire

  vice-president, Tax, Estate and Strategic Philanthropy, at Mackenzie Investments in Toronto, Ont.

• 

  Chris Long

  investment advisor at CIBC Wood Gundy in Kanata, Ont.

Georgi is married to Liesel, 53, a self-employed consultant in the tech industry. They have two university-aged children, Corinne and Jon.

Both Georgi and Liesel have significant investment holdings (see Table 1). Georgi was also a long-time member of a pension plan, so his RRSP assets are, given his income, lower than they otherwise might be.

Georgi has four main options:

• take the commuted value now;
• take the full pension at age 65;
• take a joint-and-survivor pension at age 65; or
• purchase an annuity.

With 26 years of service, Georgi would receive a lump sum of $800,000 if he was to take the commuted value. If he opts for the full pension, he would get $42,000 annually.

The joint-and-survivor option would cause Georgi’s annual pension to drop by 40% to $25,200. But in this case, after Georgi dies, Liesel would receive his pension until her death (assuming he dies first).

Option 1: Commute

To help Georgi decide if he should take the commuted value, it’s important to know how much of that $800,000 will go to CRA. Bezaire explains that a portion of the commuted value will get tax-deferred treatment; to determine the exact figure, the Income Tax Act specifies the following calculation: A (annual pension benefit) × B (Present Value Factor). (See “Present Value Factors”.)

In Georgi’s case, A is $42,000, and B is 9.4, given that he’s 50 years old.

Table 1

	Georgi	Liesel
RRSP	$350,000	$700,000
TFSA	$46,500	$46,500
Non-registered	$850,000 (joint)

This means Georgi would be entitled to tax deferral on the first $394,800 ($42,000 × 9.4). That money would go into a Locked-In Retirement Account (LIRA), notes Bezaire. A LIRA is just like an RRSP, except you can only put pension money into a LIRA, and you can’t withdraw. The funds could also go directly into a Life Income Fund (LIF), which is what you convert a LIRA into when you need income (note that it’s only possible after age 55).

This leaves $405,200. Income tax would be withheld from that amount, and with the highest bracket in Ontario now at 53%, Georgi’s after-tax proceeds would be $202,600.

Age	Present value factor
<50	9.0
50	9.4
51	9.6
52	9.8
53	10.0
54	10.2
55	10.4
56	10.6
57	10.8
58	11.0
59	11.3
60	11.5
61	11.7
62	12.0
63	12.2
64	12.4
65	12.4
66	12.0
67	11.7
68	11.3
69	11.0
70	10.6
71	10.3
72	10.1
73	9.8
74	9.4
75	9.1
76	8.7
77	8.4
78	8.0
79	7.7
80	7.3
81	7.0
82	6.7
83	6.4
84	6.1
85	5.8
86	5.5
87	5.2
88	4.9
89	4.7
90	4.4
91	4.2
92	3.9
93	3.7
94	3.5
95	3.2
96+	3.0

So, out of the $800,000, Georgi would get to keep $597,400 ($394,800 + $202,600).

Option #2: Full pension

The pension option has an inherent appeal: guaranteed income for life. The problem is that there are no guarantees.

“You need to look at the overall health of the company, because as soon as they start laying off a lot of people, you know there’s liquidity problems,” explains Bezaire.

“Pension money can be seized by creditors, which is what happened with Nortel. So, anyone left in the pension is basically going to stand behind the creditors.”

But the company’s fate needn’t be as dire as Nortel’s to make the pension option less desirable. Bezaire says Georgi needs to look closely at the trajectory of the company’s pension.

“A pension is valued by an actuary every three years, and the value has to be stable at a 7.5% rate of return (this applies across Canada). If it isn’t, the company is supposed to top it up,” she explains. “If the company can’t afford it, then the actuary is going to say, ‘We have to cut everyone’s pension by 3%,’ for example.”

Or, they could chip away at it, Bezaire adds, by taking away indexing for a year, or cutting health benefits. If any of these things are currently happening for pensioners at Georgi’s former company, it’s a red flag that more trouble may be ahead.

Chris Long, an investment advisor at CIBC Wood Gundy, notes inflation is another worry. “The pensions I’ve come across are not indexed to inflation. It’s low right now, but it will probably creep up over time.” If Georgi lives to age 95—another 45 years—the effective value of that fixed-dollar payment could be drastically reduced.

It’s also important to consider Georgi’s emotional comfort level, notes Bezaire. Is he bitter about being let go? If so, he may not want to see or hear anything from his former employer again, which will be hard to do if the company is sending him pension cheques every month for the rest of his life.

On the other hand, despite Georgi and Liesel’s considerable assets, they may take comfort in having a steady income to count on that neither they nor their advisor has to manage.

“Sometimes it may make sense, from a diversification point of view, to have something fixed to complement the risk and uncertainty of the RRIF payments based on the values of the RRIF at December 31 each year,” says Long.

Option #3: Joint and survivor

If Georgi takes the joint-and-survivor option, the monthly amount goes down by 40%. “It’s a major hit and there is no going back if his wife dies before he does,” Long says. “But for some it can make sense.”

Explains Bezaire: “If he’s not in great health, but his wife is in perfect health and has longevity in her family, they may be able to stomach that reduction.”

As it is, Georgi’s in good health, with no known reason to think he’ll die long before Liesel. Liesel’s family shows normal life expectancy, with the exception of a maternal uncle’s death at age 61 due to pancreatic cancer.

Long notes another downside of this option, which also applies to the full pension option: “Upon Liesel’s death, zero [pension money] would go to the children. This is a major consideration […] if they plan to leave an inheritance.”

Option #4: Purchase an annuity

In this case Georgi would purchase an annuity with the full $800,000. This option is “kind of an afterthought right now because interest rates are so low,” says Bezaire.

The solution

The best choice is to take the commuted value. “It would be tough to turn [it] down, short of this being the Ontario Teachers’ Pension Plan or a pension plan that’s indexed [to inflation] and comes with extended health and dental benefits,” says Long. “The reality is most pensions don’t come with that. It would be hard to go [the pension] route unless they were ultra-conservative.”

And that they are not. Georgi and Liesel had 70% equities in their portfolio for more than a decade, which they recently wound down to 55% to suit their closer proximity to retirement.

Long and Bezaire say the key challenge with pension-related decisions is the array of factors that need to be taken into account. It’s not enough to take the dollar values the employer gives and factor them into standard retirement projections. Advisors also need to help clients think objectively about the company’s long-term prospects, and address uncomfortable questions about clients’ life expectancies.

So, $394,800 will go into a LIRA, while the other $202,600 goes into the joint non-registered account. To keep occupied, Georgi will work for another five years as a part-time consultant, which will bring him to age 55. “[That’s] a magical age because [it’s when] you can unlock 50% of that LIRA and move it to an RRSP,” explains Long.

Adds Bezaire: “Many people have a sizeable enough LIRA from their pension that they don’t need the whole thing in order to create their retirement income right away. So, if you don’t need all of it, move part of it over to your RRSP and let it continue to grow while you’re tapping into the other part.”

Assuming roughly 5% growth every year, Georgi’s LIRA will be worth about $550,000 by age 55. After he moves half to his RRSP, the remaining $225,000 goes into a LIF. Long notes that CRA rules require Georgi to draw annually on that LIF money after the 50% unlocking. “Whether you want to or not, that’s part of the unlocking provisions.” The only wiggle room, he says, is that Georgi has the option to start drawing from the LIF in the year after unlocking (age 56), rather than in the year of.

To reduce OAS clawback, Long suggests Georgi should withdraw the annual maximum from his LIF until age 65, at which point he should revert to the minimums, which are the same as RRIF minimums. LIF maximums vary by province and change annually; for a 56-year-old in Ontario, it’s currently 6.57%, rising to 7.38% for a 65-year-old.

Client acceptance

Georgi thinks his former employer will be around for many years to come, but he’s not confident the annual pension he was promised is carved in stone. Reduction in payment amounts and the potential impact of inflation put him off this option. He also likes having control over his own assets. The couple’s advisor has served them well for many years and they’re confident they can do better with a lump sum.