Michael Vanderburgh is managing director and portfolio manager with Newport Private Wealth
The COVID-19 crisis has given high-net-worth Canadians reason to reflect on a wide range of financial matters—think everything from estate planning to how their investment portfolio is managed.
For those nearing retirement and expecting to draw income from a defined-benefit corporate pension plan, that conversation has taken on a new sense of urgency, in part due to the pandemic-induced recession.
In some cases, affluent Baby Boomers are accelerating their retirement dates or are being offered early retirement as employers look to thin their leadership ranks.
And one of the many retirement planning questions they’re asking is what to do with their corporate pensions. Specifically, should they take a lifetime guaranteed income (based on years worked, their age and other factors) or commute (exit) the pension and expose their nest egg to the markets, but have full control over its management?
There’s no universal answer. But employees should take a clear-eyed view of the risks and benefits of both options and weigh the factors according to their own personal circumstances and priorities.
One factor that can’t be overlooked in this economic climate is the financial health of the plan’s sponsor. It’s no secret that many Canadian corporations have underfunded pension plans, and the COVID-19 crisis is only putting added stress on their balance sheets.
A pension health index produced by Toronto-based HR and retirement consultancy Mercer Canada, dropped precipitously to 93 per cent at the end of March, from 112 per cent at the end of 2019. The index measures the ratio of assets to liabilities for defined benefit plans of the TSX-traded corporations analyzed in its model.
As former employees of fallen corporate titans such as Nortel and Sears would likely attest, pulling pension money out of a company in distress can be a wise move. Both companies had underfunded pension plans, and in the wake of their respective bankruptcies, left beneficiaries with vastly lower pensions than expected.
When a beneficiary exits a defined benefit pension program, they’re provided with a lump sum payment in lieu of that steady retirement income, thereby providing greater financial freedom and flexibility, and eliminating the risk associated with their former employer not being able to meet its pension obligation.
If a retiree wants access to their capital—say, to purchase a second home or pay off debt or to give money to their kids—commuting the pension provides them with the flexibility. Taking the monthly pension income may not afford that.
In addition, by commuting the plan, the lump sum is an asset and protects the family income if the beneficiary dies early. In contrast, pensions are lost entirely if the retiree passes away with no spouse and are usually halved upon death if they do. Consider your own health condition and family history when you make your decision about whether to commute or not.
Further, when both spouses pass, the pension disappears. Whereas, having a lump sum provides retirees with estate planning certainty and opens the door to an inheritance for their children.
The caveat, of course, is that the commuted pension must deliver an adequate income to the retiree. That means the investment portfolio needs to be properly managed, likely in a pension-like investment environment that minimizes risk and exposure to downturns such as the current one.
Not everyone wants that responsibility – even if they are working with a money manager or financial advisor. It can be too stressful for some people to have their retirement assets subject to the vagaries of capital markets and the dependability of the pension’s income stream is preferred.
There are also highly lucrative defined benefit plans where the stream of benefits may be higher than what the individual could reasonably expect to generate. In these cases, you’re probably better off taking the pension than commuting it. Knowing the specific conditions of your pension and doing a comparative analysis will help you determine this.
The best advice is to work with your advisory team—which might include a financial planner or portfolio manager or accountant—to determine an optimal pension strategy that takes your appetite for risk, tax considerations, retirement goals and estate planning objectives into account. Talk through the non-financial reasons such as health, family situation, legacy wishes.
And remember: there is no one-size-fits all answer. The decision to commute a pension (or not) could be life-changing. Take the time, and obtain the right advice, to make the right one for you and your family.