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The golden opportunity of a pension windfall might be slipping away as interest rates rise

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You have been told time and again that you are one of the lucky ones. You have a defined benefit pension — meaning that when you retire you will get a fixed monthly payment for as long as you live.

I agree you are one of the lucky ones, but not exactly for the reason that you might think. You are one of the lucky ones because you might be able to get an extra-large lump sum payout when interest rates are close to their historic all-time lows. But this opportunity could be slipping away.

As you may be aware, a low interest rate at the time you take what is called the commuted value payout of your pension, can add hundreds of thousands or even millions to the value of that payout depending on the size of your overall pension. As interest rates rise, that payout gets smaller.

The key interest rate for most Canadian pensions is the Bank of Canada five-year bond yield. This is often the number used to help calculate your commuted pension value. On Feb. 10 2016, the five-year yield hit an all time low of 0.41 per cent. That was the best day for a commuted value pension (or best month as they are usually valued monthly). As I write this, the five-year yield is now 1.14 per cent — or almost triple where it was in mid-February.

Before you think the pension opportunity is now gone, keep in mind where it has been: In March 1990, the five-year yield was 11.6 per cent. We are still at unbelievably low bond yields, and you are still in a golden period for getting huge lump sums in place of your pension. Time will tell if this golden period is coming to an end, but some analysts believe that we will never see a rate as low as 0.41 per cent again in our lifetimes.

To better understand the power of interest rates on your pension value let’s start with the humble annuity. A pension is essentially like buying an annuity. In this case you would pay a lump sum today and in return you would receive a monthly payout for the rest of your life. An annuity is also kind of like buying a lifetime GIC and locking in the rate. Today, you wouldn’t get very excited locking in a lifetime GIC that pays out 2 per cent. You also wouldn’t get that excited locking in an annuity with that type of return. For example, today you would need to put in $1 million as a 65-year-old couple in order to guarantee a payout of $51,000 a year until you both pass away. As unexciting as those rates and payouts would be, a pension commuted value is the opposite. Today it is tremendously exciting.

Thinking about that same $1 million it would cost you to receive $51,000 a year, if you take the commuted value or cash today instead of your pension, you are essentially getting paid $1 million today instead of the $51,000 a year. Another way to look at it would be how much needs to be invested at 2 per cent to pay out $50,000 a year. At 2 per cent, you would need to invest $2.5 million in order to get $50,000 a year in income. At 5 per cent, you would need to invest $1 million in order to get $50,000 a year in income. Today, your same pension commuted value payout might be $2.5 million, but if interest rates jumped to 5 per cent, it would be $1 million.

I am definitely oversimplifying a complicated formula here, and the math wouldn’t work out quite as above, but it is meant to show you the directional impact of interest rates on your pension commuted value calculation, and why this golden opportunity might slip away if interest rates meaningfully rise.

I find that many people never even consider taking a commuted value lump sum. After all, their monthly payout in retirement is what they have been working for their entire working careers. However, would you think of it differently if you knew that your employer was really hoping you would not consider taking the commuted value now?

In some cases the opportunity to take the commuted value or “take the cash” is not an option. Sometimes this is an option only at retirement or if taken prior to age 55 or prior to age 50. It is certainly worth finding out what options you have in your own plan.

When thinking about what route you would want to take in addition to thinking about your health, the companies’ health, tax planning etc., one of the key questions is whether you could earn more from the commuted value than from the pension payouts. One set of analysis that we normally do is a break-even comparison. We set things up to be as much an apples to apples comparison as possible.

In most of our pension reviews at the moment, the break even rate of return required is in the range of 3 per cent to 3.75 per cent to age 86. What this means is that if you invested your commuted value, and did monthly withdrawals at the exact same rate as you would have for your pension, you would only need to have earned say 3.5 per cent a year return to fund everything to age 86. If instead of 3.5 per cent, you actually received a 5.5 per cent long-term return, which we believe is extremely doable, you will have not only been able to match your pension payouts dollar for dollar, but would likely have several hundred thousand dollars left at the end for your estate instead of the $0 left with a standard pension.

Now this analysis will come to different conclusions in a higher interest rate world. If the break even needs to be 5 per cent+, in many cases I would consider taking the certainty of the pension. However, as long as the break evens we are seeing are in the 3 per cent range, it means you are giving up returns every year. We believe that taking the commuted value of a pension, if you are lucky enough to be able to do so in today’s interest rate environment, is something to consider strongly.

I am not suggesting that it is always wrong to keep your pension. In most cases, a government or quasi-government pension provides you with certainty on income for the rest of your life. If you and/or your spouse have good genes and are in good health, it is quite possible that you will receive the pension for extra years compared to your peers. There are also sometimes health benefits attached to a pension that provide some real value and peace of mind.

The decision of whether to receive a pension in monthly amounts for life as opposed to taking a lump sum is a complicated matter. What I do know is that your employer believes that paying out the commuted value today will cost them too much, and would likely prefer you don’t even consider it. That is reason enough for you to explore it further.

Reproduced from the National Post newspaper article 6th February 2017.

Ted Rechtshaffen
Written By:
Ted Rechtshaffen, MBA, CFP
President and CEO
tedr@tridelta.ca
(416) 733-3292 x 221

How the Bank of Canada’s rate cut may have added $100,000 to your pension in one day

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When the Bank of Canada lowered the overnight interest rate by 0.25% this week, the obvious benefit is for those with variable rate mortgages. They will see an immediate benefit in lower interest payments on their mortgage.

Another group who just received a big win may not even realize it: If you have a pension plan, and especially if you have ever thought about taking the cash value of your plan, you just saw an increase in potential value. In some cases, the rate cut could have added as much as $100,000 in wealth in one day. This option to ‘take the cash’ is usually open to those who are retiring or leaving their employer. Sometimes the option ends when the employee turns 50 or 55.

To understand how this wealth boost works, and how much your wealth could go up, can get a little complicated. The best way to explain it is to pretend that you want $50,000 of income per year and go from there.

You could buy a GIC to pay out $50,000 of income per year, and depending on the interest rate of the GIC, you could determine how much you need to invest: At 10 per cent interest, you could buy a $500,000 GIC. At one per cent interest, you would need to put in $5 million for the same return.

In the pension plan example, if they are committed to paying you $50,000 a year, then at today’s super low interest rates, your pension plan must set aside a lot more money to cover off $50,000 a year — just like the GIC example. Here is where your wealth potentially just grew:  In many cases, you have the ability to ask your pension plan for this lump sum of money (often called the commuted value), rather than taking the pension as a monthly payment.

Below is a chart for the Bank of Canada Five-Year Bond Yield over the past 26 years. The highest yield was 11.6 per cent, in March 1990. The lowest yield happened this week at 0.7 per cent.

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Imagine this chart represented an opportunity to lock in a lifetime rate for a loan. If you could choose any time to lock it in, this week would be the best time.

A commuted value of a pension works the same way. You are essentially locking in a value for life, and an important determinant of that value is interest rates.

Put another way, if you were ever going to take the commuted value of your pension, now would be one of the best times in history to do so.

For those who like the idea of a monthly payment guaranteed for life, you can purchase a pension any time by buying an annuity. Having said that, in many ways, at today’s low interest rates, now is perhaps the worst time to purchase an annuity.

One potential strategy is to take the commuted value of your pension today, when you would receive the largest amount. In a few years, if interest rates rise meaningfully, you can take your funds and buy an annuity that will pay you a higher monthly amount than you would ever have had with your existing pension.

The decision of whether to receive a pension in monthly amounts for life as opposed to taking a lump sum is a complicated matter. What I would suggest is that your pension plan does NOT want you to take a commuted value lump sum today. It will cost them too much.  Based simply on that, you may want to take a good look at whether that option is open to you, and whether you might want to take it.

Reproduced from the National Post newspaper article 17th July 2015.

Ted Rechtshaffen
Written By:
Ted Rechtshaffen, MBA, CFP
President and CEO
tedr@tridelta.ca
(416) 733-3292 x 221

Here’s why you should show your group pension plan some love

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If your boss offered you a $5,000 raise for the same amount of work, would you say no?

That fact is that many Canadians are turning this down by not taking advantage of their companies matching of RRSP contributions.

The obvious reason is that money is tight for many people and the idea of having less in your pocket each paycheque can be painful. But the question must be asked: What else are you doing with your money that will return 100% (if there is full employer matching)?”

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Your Pension – Is now the time to take the cash instead?

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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.

  1. 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.
  2. 14735352_sWhat 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.
  3. 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.

  4. 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.
  5. 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.
  6.  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 tedr@tridelta.ca or by phone at 416-733-3292 x221 or 1-888-816-8927 x221

Reproduced from the National Post newspaper article 7th August 2013.

Welcome Home!

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Are you a Canuck residing in the US, but planning to return to Canada?

We have had many inquiries recently from Canadian citizens living in the US, who are considering moving back to Canada, wanting to know their options.  There are many things to consider before returning home.

While Canada offers many wonderful things to those returning home, such as safety, great public services, freedom, being close to family, seeing old friends and a system you can trust. It is also a move back to the land of taxes, rules and regulations, rain and snow. Whatever your reasons for returning, there are many things to understand before making this move.

The biggest question is Why do you want to move back to Canada?  The answer to this involves learning about what is important to you – what you want life to offer you and what changes you are willing to make and what costs you’re likely to incur if moving to Canada is the right choice for you.

Once you have answers to the following questions, you will be able to make a more informed decision:

Where do you plan to settle in Canada. Different provinces offer different amenities, services, and taxes. Will you buy or rent. Did you know that only Canadian sources of income are considered for a Canadian mortgage.

Understand the changes to your tax situation. How will your income be taxed, do you need to file  tax returns in both Canada and the US and for how long? Understand when you are deemed a resident and the tax consequences of this. Have you done a before and after tax comparison. How will a move affect your estate plan.

Prepare your finances. Prepare a summary of Lifestyle expenses. What costs more, what costs less and determine if you can afford the move and changes. Did you know you may be able to combine US Social Security and the OAS payments. Is this the right option for you. How does this fit with your capital preservation goals.   Are assets joint for estate purposes. If you have a foreign Pension, can it be paid into a Canadian account. How will you access these funds.15882723_s

Do you have a US green card? Should you keep it and what are the implications of this.

Do you have insurance i.e. life, disability and/or long term care? If so, is it good for services in Canada, or only within the USA.

Will you keep funds outside of Canada? What are the implications of this.

Do you have pets?  Understand what is required to bring these into Canada.

Do you have a drivers Licence and vehicle? Can you  “convert” your current licence to a driver’s license in the province you will be living in. Can you bring your car with you. You can only import cars from the U.S. and only under certain conditions.

Understand Health Care in Canada. Know the rules in different provinces. There is no coverage for the first 3 months if you move to British Columbia, Ontario, Quebec, or New Brunswick. Other provinces do not require a waiting period. You may need to buy 3 months of health insurance in Canada or go three months without health insurance. You assume the risk and potential costs of any health issues that come up within that time period.

Research the availability of medical services. What are the services and availability of a family doctor in the area where you want to live. Some doctors in are not taking on new patients. Some services have a 3 to 6 m delay.

Friends?  If you have made deep friendships in the U.S., you will have to make new friendships or renew old ones in Canada. The older you get the harder it is to make significant friendships. Is it worth coming back to Canada?

Quality of Life. Will your quality of life and bottom line improve by moving to Canada vs. the US. What are you are giving up. Some feel Canada is expensive, cold, and dark in the winter. Some things do cost more , such as taxes, gas and groceries, however other things may cancel that out, such as not having to pay for costly health insurance premiums and deductibles and at 65, receiving minimally costing drugs.  Only you can determine your cash flow and what makes sense for you.

As long as you have weighed your options and know what the bottom line looks like, the next step is to make the decision about returning home.

Regardless of your choice, TriDelta Financial can assist you in managing your assets on both sides of the border and connect you with a team of mortgage, tax, investment and legal specialists to assist you in making your transition smoother.

Heather can be contacted by email at heather@tridelta.ca and by phone at (416) 527-2553.

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