Wednesday, May 15, 2019

Should You Withdraw the Commuted Value of Your Defined-Benefit Pension?

No. There are some exceptions, but the answer is almost always no. In fact, if a financial advisor is pushing you to pull out the commuted value of your pension, that’s a sign that you’re likely working with a bad advisor.

There is almost no chance that your advisor will choose investments that outperform a pension fund, mainly because the total fees you pay with an advisor are so much higher than the fees charged within a pension fund. Some advisors will tell you that you won’t pay any fees because the mutual funds pay the advisor. Don’t believe this. Mutual funds and advisors get paid out of your savings.

Further, defined-benefit pensions have the advantage of handling longevity risk. Pension funds can afford to pay you based on your expected life span, and they’ll keep paying if you happen to live long. With an advisor managing your money, you need to hold back on your spending in case you live long.

There are some cases where it makes sense to withdraw your pension’s commuted value. Here are a few:

1. Poor health makes you likely to die much younger than average. In this case, taking the commuted value allows you to spend more now or leave a larger legacy.

2. You’re employer’s pension plan is badly underfunded and the company is in financial difficulty. A good example of this was Nortel. The Big Cajun Man was fortunate to get the full commuted value of his Nortel pension before pension payments were cut.

3. You leave an employer long before retirement age, and the pension plan rules make the commuted value more attractive than future pension payments. It’s important to make this determination based on modest return expectations for your portfolio. The fees you’ll pay an advisor severely dampen investment returns over long periods.

I’m sure it’s possible to come up with other narrow exceptions, but you should be very wary of advisors who push hard for you to withdraw the commuted value of a defined-benefit pension. These advisors have strong incentives to increase their assets under management to get more fees. Don’t be swayed by advisors who claim they can generate big investment returns.

17 comments:

  1. You completely overlooked the idea of taking the commuted value and investing in a balanced ETF portfolio or one ETF solution (VEQT, XGRO, VGRO, etc.). This saves you from the fees from an advisor while only paying a meager MER (0.20% - 0.25%) and would be expected to perform the same as the market.

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    1. @Unknown: This post was intended for those who have an advisor telling them to take the commuted value with the intention that the advisor would manage the money.

      Managing the money yourself is certainly an option. That's what I'm doing myself with a pension commuted value in a LIRA that I took back in my early 30s. However, it's a rare person who can just "let it ride" without making some active decisions over the decades that reduce returns. Combine this with the problem of longevity risk, and keeping the pension is usually the better choice even if you keep your expenses very low.

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  2. Whether your pension is indexed or not should figure into your decision. A few years of abnormally high inflation can really hurt an non indexed pension. Even ordinary inflation can cut the value considerably over a long period, especially for early retirements.

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    1. @Garth: Indexing is very important with pensions. However, indexing is taken into account when computing the commuted value. So, if you take the commuted value, you'll get much less money with a non-indexed pension.

      I agree that a lack of indexing makes taking a commuted value more enticing because of inflation risk. It is possible to invest on your own in a way that reduces inflation risk. However, you're still faced with longevity risk. In most cases, it's still better to keep the pension.

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    2. If it makes it possible,I would encourage those with a non-indexed pension to use the commuted value to bridge the gap to deferring CPP and OAS to age 70. Something else very few advisors would suggest.

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    3. @Garth: If the commuted value is small enough that it would be consumed bridging this gap, then I agree. But if it's much larger, the pension is likely the better option.

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  3. @Michael Perhaps your post is a good response to "Should you allow a financial adviser to push you to withdraw the commuted value of a defined benefit pension and put it into a bad portfolio of investments?".

    However, my wife recently changed jobs and we had to make a decision on whether to withdraw the commuted value of her pension. I would say that generally, if the following are true:
    1. You have many years left until retirement
    2. You have a well-diversified and low cost investment strategy (whether it be self-directed or via a fee-only adviser)

    Then I would say you are almost always better off withdrawing the pension.

    From my research on this subject, pension plans are obligated to compute a commuted value of your pension such that (strong paraphrasing ahead) if invested at a very low-risk rate that you should be able to then purchase an annuity to provide the same level of income that the defined benefit pension should provide. When I ran the numbers on my wife's benefits and commuted value, I found this to be roughly true.

    A couple of sources on this:
    https://www.cia-ica.ca/about-us/actuaries/ask-an-actuary/faq---pensions
    And a spreadsheet you can find by following a pointer in the above:
    http://an-actual-actuary.com/Pension%20Plan%20Interest%20Rates.xlsx

    Since the calculations are based on low interest rates, if you have a long time horizon and can invest sensibly, it is reasonable IMO to take more risk than the CV is based on, grow it to an amount that should be able to provide income than the DB pension would have provided.

    Without a doubt, there is some risk here, but the more time you have until retirement, the reasonable I feel it is to take this risk.

    If, as you allude to in your post, you are being pressured by an unscrupulous adviser into withdrawing your pension and putting it into a poor investment portfolio, IMO the question is less about withdrawing the pension's CV and more about finding a good adviser. Is this the only bad advice that would be provided by this adviser? Wouldn't they also take the rest of your savings and invest it poorly as well?

    Withdrawing the CV isn't a no-brainer. Tax consequences must be considered. It comes in 2 parts: non-taxable to be transferred into a LIRA, and a taxable amount. In our case we used all available RRSP room to shelter as much of the taxable portion as possible. This still left a large amount to be taxed. This large amount ends up being taxed at a high rate, because the large amount is added to your income for the year, which pushes you into a very high income bracket. This was true with a fairly modest pension amount.

    If you look at it another way, if you are > 20 years to retirement, the payout has to be so large because it is based on a low rate of growth (much lower than the pension fund is likely to achieve) that you are going to get so much money that you will likely use up all of your RRSP room. The fact that they are giving you so much money that you have to be taxed on a good chunk of it is more of a testament to how much money they are giving you than it is indicative of it being a bad deal.

    Every situation needs to be analyzed in its entirety, but I would tend to suggest withdrawing the CV is the way to go as long as you are smart with how you handle it. When close to retirement though, there may not be enough time left to grow the payout at a reasonable risk level to justify taking the risk.

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    1. @Returns Reaper: You're right that if all the caveats you mention apply, then taking the CV can work out better than taking the pension. My claim is that these caveats apply in a very small fraction of cases. Most people's portfolios don't beat inflation by much if at all. They make costly mistakes of various types. For every 100 investors who conclude they can manage their CV themselves and do better than taking their pension, I doubt that even 10 will turn out to be right. Even fewer will get a better outcome taking the CV if they work with an advisor.

      You're right that "Every situation needs to be analyzed in its entirety," but most people will bake in unrealistic assumptions about the returns they will get investing on their own. This may not apply to you and me, but there are a great many people who will wrongly think it doesn't apply to them.

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    2. I don't disagree that a good chunk of the public don't do well with their investments. However, I think saying that most people shouldn't take the CV is the same as saying most people should invest in GIC's, since the rates CV values are calculated on appear to be close to GIC rates. Perhaps you would agree with this statement (based on the investing abilities, or more accurately tendencies, of most people).

      Also, I think it wouldn't be unreasonable to think that once the average person has taken their CV and paid tax on the taxable part, they might be inclined to frivolously spend that portion rather than invest it. This "real world" tendency is another reason to keep the DB pension.

      However, I do find this line of thinking somewhat incongruent with the typical content of your blog posts, which tend to be tailored towards more of a savvy audience.

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    3. @Returns Reaper: Based on the commuted values I've seen, the discount rates in the spreadsheet you pointed to are real rates (above inflation). So, they're not GIC-like rates. If you disagree, please let me know.

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    4. @Michael, my interpretation of the rates are that they use the average > 10 yr. Government of Canada average bond yield + 0.5% for 20 years. So right now that is about 2.4%. I think this is very close to what you can find GIC's for now. It is hard to find GIC's with a 20-year term, if that is your term to retirement. So this still isn't without any risk since you'd end up buying multiple 5-year GIC terms, where the rates can fluctuate between terms. But if you are 20 years from retirement, cashing out the CV of your DB pension is a good deal if you can beat a 2.4% return over that time period.

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    5. @Returns Reaper: It took some digging, but I think I figured out how the interest rate tables are used. For fully indexed pensions, the discount rate is currently a blend of 1.3% (real) for the first 10 years 1.5% (real) thereafter. There are different rates for unindexed pensions or partially-indexed pensions. For unindexed pensions, the first 10 years are discounted at 2.5% and 3.1% thereafter. This is close to current GIC rates. However, the indexed pension discounting is closer to expected long-term returns from balanced portfolios. After we account for the cost of longevity risk, I stick by my claim that most people are better off keeping their pensions, even for more savvy investors. If I had an indexed pension to begin paying soon, and I trusted that the pension plan wouldn't default, I would take the pension and not the commuted value to invest myself.

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    6. @Michael: I do agree with you when close to receiving the payments, you are probably better off to keep the pension. When you get into longer time-frames, I think you are almost always better off taking the CV. In my situation, we were about 25 years from receiving the benefit. The CV, after using available RRSP room and paying tax netted about 13x the annual benefit in tax-deferred capital and about 2x the annual benefit in post-tax capital. To me, taking the CV and investing seemed like a clear win. With 25 years to grow the money, there is ability to take risk and I believe the odds are that we will come out ahead.

      Also, the longer you are from collecting, the greater the odds that the pension fund will take a bad turn. Currently, it is well funded, but there are no guarantees (although -- if the pension fund takes a bad turn, it is likely my investments have also taken a bad turn, so perhaps this is a wash).

      If I was close to retirement, I agree the value of a guaranteed payment is worth a lot to offset longevity risk. I would be much less likely to take a large lump sum and take risk with that money, given the shorter time-frame.

      Slightly off topic, but related, I think using your savings to defer CPP and GIS are a reasonable way of buying a gold-plated annuity from the government. Particularly if you have a large tax-deferred account and drawing down the balance somewhat early in retirement helps you keep your retirement income low enough to avoid the OAS clawback after your tax-deferred accounts convert to an RRIF, and minimum withdrawals being.

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    7. @Returns Reaper: I think we're very close to full agreement. It's a pleasure to have civil discussions to sort out areas of disagreement. Too bad we can't have more of that in politics.

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    8. @Michael: lol, I definitely agree with that!

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  4. Another narrow instance where an investor may choose to take CV is if the pension payments compromise their GIS eligibility.

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    1. @Steadyhand_chris: Good point. I'm not sure where people like this would go for competent advice, though. An advisor or money manager is unlikely to make much from those who collect the GIS. Maybe some robo-advisors will automate GIS advice.

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