Defined benefit pension plan members facing pandemic-related permanent layoffs will have to make an important financial decision: take the lump sum now or the future pension later.
Canadian pension plans must give terminating employees who are not eligible to start drawing their pensions yet the option of portability. That means giving up their lifetime monthly retirement pension for a lump sum settlement, known as the commuted value.
Although the coronavirus pandemic might cause some delays, the commuted value option is still on the table.
The commuted value of a pension is the sum of the future monthly pension payments, adjusted for interest from now until the monthly payments are scheduled to be paid. With today’s rock-bottom interest rates, lump sum settlements are bigger than ever. But before you go that route, take a moment to consider why they’re so big.
Negative bond returns
A bond normally pays a positive return to the buyer because the sum of all interest and maturity payments from the issuer exceeds the purchase price. If the bond is resold at a higher price, then the new owner will get a smaller return on their investment. Bond prices have been rising, so the return to buyers has been going down.
At the end of July, the price of a government of Canada real return bond maturing in 2044 rose to $142 for every $100 of face value – even though the government will only pay out $137 in today’s dollars between now and when the bond matures. In other words, the real (inflation-adjusted) return on this bond will be negative. The prices of non-indexed government of Canada bonds are also trading at record-high prices, with returns (in nominal dollars) very near zero.
If you’re a member of an employer-sponsored pension plan, those high government of Canada bond prices are used to calculate the lump sum settlement offer included with your pension option statement, making the offer eye-popping. But should you take it?
The value of income security
Here’s the catch: Guarantees are expensive. What we’re seeing in bond prices is the going price for guaranteed future income. The rise in commuted values is driven by the decisions of professional fund managers who are choosing to pay record-high prices for government bonds instead of investing in riskier assets with the potential for greater returns.
And just as the price of guaranteed bond payments is high, so is the price of your guaranteed future pension. The goal of a commuted value calculation is to strike a fair balance between the interests of the individual who is giving up their pension, and the interests of their employer and the other plan members.
The commuted value represents the economic value of expected future pension payments, with no add-on for the risk that the individual might live longer than normal, or inflation might be higher than expected. There are also no adjustments for fees, or the risks and rewards associated with managing investments.
That means, as high as the commuted value may be, it’s not high enough. If you try to buy the same pension income in the retail market by purchasing an annuity, then you will have to settle for fixed annual increases, rather than true inflation protection linked to CPI increases. And the fixed rate of increases you can buy is very low – much lower than the Bank of Canada’s 2-per-cent inflation target.
Taxes are another consideration. The commuted values are transferred to a locked-in account, but these large values will almost certainly exceed the maximum tax limit. Unless it is used to buy a “copycat” annuity – a life annuity from an insurance company that copies what the pension would have paid – the excess is taken as cash and will be hit with a significant tax bill.
A personal decision
Choosing a lump sum over a lifetime pension payable at a future retirement date should come down to individual circumstances, not investment prospects. The key consideration is whether you need that pension to cover your regular monthly expenses.
Just like professional fund managers, your choice depends on your investment objectives, evaluated against the prices and risks of each alternative. If you value the inflation and investment protection of a lifetime pension, then you should seriously consider whether the risks in the stock market outweigh the possibility of better returns.
It’s hard to imagine, but your retirement could span 30 years or more. Over time, your health and personal care expenses are likely to increase, along with your need for secure income with less risk.
Retirement planning requires a long-term perspective – and the simplicity of secure monthly income is a precious gift you can give to your future older, more vulnerable self.
Doug Chandler is an independent research actuary based in Calgary. Bonnie-Jeanne MacDonald, PhD, is the director of financial security research at the National Institute on Ageing at Ryerson University and resident scholar at Eckler Ltd. Both are fellows of the Society of Actuaries and fellows of the Canadian Institute of Actuaries.