Here is a little known pension fact.
When interest rates are low, the present value or commuted value of your pension is high. When rates are higher, your pension’s present value is lower. The difference could mean getting $250,000+ more on a full pension if you retire today, than if you retire when rates are 2% higher. Even better, someone can take the cash today, invest the funds, and in a few years when interest rates are higher, they can buy an annuity to effectively lock in a better pension.
What this means to you is that if you are close to or considering retirement with a fixed or defined benefit pension, with interest rates still near historic lows, you should take a hard look at whether it makes more sense to take the cash instead of the pension.
Of course, every situation is different, so here are 6 factors to consider before making the big decision to either take the pension or the cash.
- When do they think you will die? This is a serious question without a definitive answer. Having said that, your current health plays a significant part, along with looking at the health of your parents and siblings, and that of your spouse. A traditional pension is worth $0 after the pensioner and their spouse have passed away. If that is going to happen 10 years after retirement, that is a lot of money that will disappear. In a nutshell, if you think you will live well into your 80’s, taking the pension is likely a good bet. If you think that you will be lucky to reach 75, then taking the cash is very likely the better option.
- What rate of return do you need to outperform your pension? A financial calculation needs to be made based on life expectancy to determine what rate of return would be needed on the cash, to be equal to the value of the pension. Sometimes this break even rate is as low as 2% or 3%. In these cases, taking the cash is likely the better option as you’re likely to have at least 4%+ annual returns over time, possibly over 7%. This can add hundreds of thousands of dollars to your wealth. If the break even number is 5% or higher, meaning you need to get better than 5% annualized returns to end up better, then the pension is probably a better bet on this factor – because of the guaranteed nature of pensions.
- How healthy is the organization and its pension plan likely to be for the next 35 years? This answer would be based on a number of factors facing the company in the future. One important one is how well the plan is funded today. The credit rating agency DBRS released a major report on pension plans last month. One of the more interesting items is that it listed the major Canadian firms that were most underfunded as a percentage of its pension requirements. The following 12 companies were all underfunded by more than 30%. The numbers show the percentage funded as of December 31, 2012.
- Magna International 55.4%
- Catalyst Paper Corporation 60.3%
- Canadian Oil Sands Trust 62.1%
- Barrick Gold Corporation 63.1%
- Agrium 64.6%
- Talisman Energy Inc. 67.4%
- Norbord Inc. 67.7%
- Toromont Industries Ltd. 68.0%
- Emera Inc. 68.3%
- Suncor Energy Inc. 68.7%
- TransAlta Corporation 69.3%
- Imperial Oil Limited 69.7%
Some major US companies appear even worse:
- Moody’s Corp 47.0%
- Tesoro Corp 51.2%
- Masco Corp. 56.3%
- U.S. Bancorp 56.7%
- Stryker Corporation 56.8%
- American Airlines 57.0%
- Procter & Gamble 58.8%
If your company or its pension is in trouble, you can expect your pension to get squeezed. This could mean accepting 90 cents on the dollar, or losing some inflation indexing or health benefits. In some cases, the “guaranteed” pension, isn’t so guaranteed after all.
- How much flexibility is needed on cash flow? Pensions are great because they provide consistent cash flow, but what happens if you want to spend $100,000 in your first year of retirement, but will only need $40,000 in your 20th year. The pension isn’t flexible on that front. What if you want to help one of your children with $50,000 today? This cash flow flexibility can open be of value. This also has some tax implications in that you have no flexibility to adjust income for tax reasons based on your personal circumstances. For some this won’t be a meaningful issue, but in certain cases, especially with sizable inheritances, your financial situation may change during retirement, and you may want the flexibility to adjust. When you get into the Old Age Security zone, in some cases this flexibility will allow you to receive more or all of your OAS for many years.
- Do you want to leave money to your kids? As mentioned, one of the drawbacks of a pension is that when you are gone, so is the pension. One option some people use to make their pension last into the next generation is to have the pensioner take out life insurance. The basic strategy is that where possible, if the retiree is in decent health, it makes a lot of sense for them to take a pension with no spousal benefit. This will make the monthly pension amount higher than any other option. The problem is that if the pensioner passes away early, what happens to the spouse? In this case, the spouse is well taken care of because they will receive a meaningful life insurance payout in place of the spousal pension (which is usually about 60% of the pension value). The other possibility here is that if the pensioner outlives their spouse, they will benefit from receiving a higher monthly pension for their entire retirement, and there will still be a life insurance payout for their beneficiaries.Depending on your lifestyle needs and the portfolio performance, taking the cash may be more likely to leave you with more of an estate, especially given that a traditional pension is guaranteed to be worth $0 upon the death of both spouses.
- Tax Planning. One potential negative of taking the cash is that in many cases only a portion of the funds will be tax sheltered in an RRSP or RRIF or LIRA. Another portion may be considered taxable income in the year received. For a large pension, this could mean a one-time taxable income of several hundred thousand dollars. Fortunately, there are some tax strategies which can lower the tax rate on that lump sum by over 10% or effectively cutting the tax bill by over 20%. With the pension keep in mind that every dollar is taxable, but there isn’t usually any large lump sum related tax hit.There is no question that a defined benefit pension brings a level of security that is comforting to retirees. Having said that, even the pension is not fully guaranteed. When you look at the current level of underfunding, and then think about how many major companies have gone bankrupt over the past 20 years (Nortel, Kodak, Lehman Brothers, etc.), you realize that there is some real risks that you will be receiving some meaningful percentage less than 100 on your “guaranteed” pension.When you factor in your likely longevity, a financial analysis, cash flow flexibility, estate issues and taxes, it is not an easy decision to make. When you add in the rare benefit of low interest rates and the impact that can make on enhancing the lump sum value of your pension, taking the cash should become a meaningful consideration to think about. One other strategy for couples where both will have a defined benefit pension, is to keep one pension and take the cash on the other. Usually you would take the cash for the person who may have weaker health or is with a shakier organization.While the big benefit of a pension is that you will have an income for as long as you live, most people can achieve the same thing with an income oriented portfolio with a low long term risk profile. A portfolio of large companies with low debt ratios, and a history of increasing dividends, along with individual bonds and select preferred shares should be able to provide a similar experience to a fixed pension.The bottom line is that the pension decision is among the most important financial choices you will ever make. Take the time and get the information you need to make the right decision for you and your family.
Ted can be reached at firstname.lastname@example.org or by phone at 416-733-3292 x221 or 1-888-816-8927 x221
Reproduced from the National Post newspaper article 7th August 2013.