No contest

  By Guest Blogger Sinan Terzioglu

My wife recently left a job where she participated in a defined benefit pension plan for a number of years. She was given the choice of deferring the pension (leaving the pension in place), transferring to another pension plan (if she would be participating in a new plan and it was permitted to transfer), taking the commuted value (lump sum) and investing it ourselves in a locked-in retirement account (LIRA) and/or taking a lump sum cash payment (taxable).

Needless to say we had a lot of factors to consider when deciding what the best decision was for us.  Everyone’s goals and circumstances are different so it’s certainly not a one size fits all sort of decision. Some DB pension plans have additional benefits which further complicates the decision. For example, are payments indexed to inflation and/or are there medical benefits.

The certainty of regular monthly income for the rest of your life is very tempting.  That said, there are no guarantees as many pension plans are underfunded and many corporate pension plans have gone bust over time. A defined benefit pension is basically like buying an annuity because both will give you income for life but when you pass away the remainder is lost. Some DB pensions allow payments to continue to a spouse for a certain period of time but at a reduced level.  However, if/when the spouse passes the payments don’t continue for any kids or family members. This was a tough one for us to accept.

For my wife and I, it came down to the numbers.  For example, suppose a DB pension plan offered you $2,000 per month for life starting at the age of 60 (not indexed to inflation which has averaged ~3% over the long term).  You are 35 now and the commuted value is ~$170,000. You are able to commute the entire value to a LIRA and avoid paying taxes until withdrawals begin (earliest 55).

When comparing to an annuity you learn that a 60 year old buying an annuity in a registered account provides ~$10,000 a year for every $200,000 worth of annuities purchased.  So to get an equivalent monthly cash inflow starting at the age of 60 you would need to purchase ~$480,000 worth of annuities. Now at this point you need to determine what rate of return you would need to grow $170,000 into $480,000 in 25 years. The compounded annual rate of return (CAGR) required is 4.24%.

Over the last several decades a diversified and balanced portfolio has produced a CAGR of 7%.  Investing $170,000 for 25 years earning a CAGR of 7% would grow to ~$922,000 and continue to grow over time. This amount of money would produce consistent interest, dividends and capital growth.

If you pulled 4% a year that would give you over $3,000 a month and the money would still grow.  If you pulled 6% a year that would give you ~$4,600 a month starting at the age of 60 without drawing down the principal.  Also, a diversified portfolio consisting of dividend producing equities is like having an inflation hedge because dividends grow over time and often at a higher rate than inflation.

My wife was able to commute about half of her pension to a LIRA so we avoided paying taxes on that portion.  The other half was paid out to us in cash so we had to declare it as income and pay applicable taxes. Many struggle with this part but for us it was a no brainer because we know we’d eventually have to pay tax on the pension income anyway and now we are able to invest the funds in our non-registered joint account which has several benefit.  Plus, we’ll pay less tax over time because a portion of the non-registered amount can be paid as return of capital which is not added to taxable income.

Another big reason we decided to commute my wife’s pension is so we can have control.  We are able to control the frequency of withdrawals and how much.  If we choose to spend more in our early retirement years we have the ability to do so because we control the money.

An analogy I like is to think of a pension as if you are taking a fixed amount from a pile of money (not indexed to inflation). The pile never runs out but the pile and what you take from it never grows either.  When you pass away the pile of money pretty much disappears. You can’t control how much you take from the pile nor when.  However, if you commute the pension and invest it then the pile of money becomes yours and has the potential to grow throughout the rest of your life. When you pass away the pile of money is left for your family and continues to grow.

Sinan Terzioglu, CFA, CIM, is a financial advisor and licensed portfolio manager with Turner Investments, Private Client Group, Raymond James Ltd.