In an increasingly complex world, the Financial Post should be the first place you look for answers. Our FP Answers initiative puts readers in the driver’s seat: you submit questions and our reporters find answers not just for you, but for all our readers. Today, we answer a question from Andrew about commuting his pension so he can retire now, four years before he turns 60.
By Julie Cazzin with Allan Norman
Q: I am conflicted on whether I should wait to take a defined-benefit pension in four years at age 60, which would be approximately $80,000, or take a transfer value of $1.1 million and retire now. The market right now scares the crap out of me, so I haven’t done it. What would taking the transfer value look like? I have maximum contribution room in my and my spouse’s registered retirement savings plans (RRSPs). — Andrew
FP Answers: Andrew, before commuting a pension, make sure you’ve taken a good long look at yourself in the mirror. Most people with a pension think and behave differently than those with a large lump sum of money to manage.
Finding a financial planner to do some projections and compare commuting a pension with not commuting is easy. The hard part is anticipating the impact of your choice and how it will affect your lifestyle. Try to gain a better understanding of how you might behave managing a $1.1-million portfolio.
To help you think about how your behaviour may change, I’ll lean on a 2021 study by the Washington, D.C.-based Employee Benefit Research Institute (EBRI) that took a look at why people spend the way they do in retirement.
The study found that 57 per cent of retirees want to grow, maintain or slightly decrease their investment portfolio. Only 43 per cent per cent were comfortable spending down their capital.
Andrew, if you commute your pension to a $1.1-million investment portfolio, how comfortable will you be depleting it over your lifetime to match what the pension would have provided? What makes you think that?
EBRI also explained the top reasons, by percentage, why retirees don’t want to draw down their investment portfolio by a large amount: saving assets for an unforeseen cost later in retirement (38 per cent); feeling that spending down assets is unnecessary (37); wanting to leave as much as possible to heirs (33); simply feeling better when account balances remain high (31); and, fear of running out of money (27).
Fear of running out of money
Without a large investment portfolio to manage, and a regular pension income, those thoughts likely won’t even cross your mind. With a large investment portfolio, some of those reasons for not spending down your portfolio will pass through your mind and you may restrict your spending, even if the math says you can spend more.
I have clients right now with portfolios around $1.1 million and they’ve stopped drawing from their investments because markets are down. They’re being cautious, but they also don’t want to see their portfolio slip below $1 million. It’s a feel-good thing for them.
Now, there are reasons why commuting a pension may make sense and they often revolve around things such as a shortened life expectancy of the pensioner, partner or both, wanting to leave money to heirs or wanting a higher income earlier in retirement.
There are often some tax consequences when a pension is commuted. Generally, most of the commuted value will transfer tax free to a locked-in retirement account (LIRA), and the remaining portion will be taxable.
The taxable portion can go to an individual’s RRSP and/or their partner’s RRSP, depending on contribution room and individual tax rates. Any remaining money would generally go to tax-free savings accounts (TFSAs). These are the kind of decisions a financial planning session will help you with.
The accompanying table shows some ballpark estimates of the annual income you might expect from a $1.1-million portfolio.
I assumed a base inflation rate of three per cent and a starting date of Jan 1, 2023, when you may be age 57. I’ve also used different investment rates of return to demonstrate how small changes in assumptions can have a large impact on the results. I also wasn’t sure if your pension was indexed or not, so if your pension is indexed, compare it to the figures in the indexed column.
If you commute your pension, Andrew, will you be comfortable drawing it down at a rate to match what would have been your pension income? And how do my ballpark figures match your $80,000 pension if you wait four more years?
Finally, financial projections are just that, projections, based on assumptions that may or may not come to be. A pension plan on the other hand is pretty close to a guaranteed income for life.
Allan Norman provides certified financial planning services through Atlantis Financial Inc., and conducts securities related business through Aligned Capital Partners Inc. He can be reached at www.atlantisfinancial.ca or email@example.com.
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