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Benefits and Pensions Monitor

Pension Choices In Context

By: Patrick Longhurst

After a long career working with companies designing pension funds, Patrick Longhurst, of Patrick Longhurst Advisory Services Inc., is finding personal situations have a tremendous impact when it comes to helping individuals plan for retirement.

After 30 years of advising corporate clients on the design and funding of their retirement plans, I have spent the last year providing advice to plan members on the pension choices available to them. This has been something of an epiphany for me! When you deal with a plan sponsor you are thinking of average outcomes over a large group of members. When you work with just one of the members, you see the impact of the plan on the individual.

And the personal situation of the individuals concerned has impacted on the decisions they have taken in ways I never would have imagined.

In corporate work, the basic tool is the actuarial valuation which compares the assets and liabilities of a Defined Benefit pension plan and calculates the required contributions for the plan sponsor.

In individual work, the basic tool is the financial planning model which compares the value of an individual’s expected expenses in retirement with the value of their financial resources and calculates the savings strategy necessary to balance the two.

There are many models out there, from the very simplistic, which you can find on any website, to the ultra-sophisticated which may provide more information than you can possibly use.

For me, the key is to see the interaction of the various sources of income and outgo, and to test the financial impact of various savings and tax-planning strategies.

Commuted Value Versus Pension
The first case involves a plan member aged 60 who has the option of taking a single life annuity of $60,000 per year or a transfer to a Locked-in Retirement Account (LIRA) of $600,000. A traditional analysis would be to calculate the rate of return, net of expenses, which would be required to duplicate these payments. This would be:

• Approximately eight per cent if the member lives to age 80
• Approximately nine per cent if the member lives to age 85
• Approximately 9.5 per cent if the member lives to age 90

So the decision looks clear for the member. If he expects to live to age 85, he has to be able to earn a rate of return after expenses of nine per cent in order to break even. But the member actually has many other issues to consider. These include:

• The flexibility of a lump-sum over a guaranteed pension
• Their attitude to the risks involved in investing a large amount
• The impact of inflation on their decision
• Integration with their overall financial planning

While the first three of these issues are fairly straightforward, the fourth one is more intriguing. You only really appreciate(d) the impact when a financial model is created for the plan member. In this case, the result was that he needed a rate of return of far less than eight per cent to break even because, in addition to the pension entitlement, the member had some non-registered investments. If he took the lump sum he could live on the nonregistered money for a number of years before touching the registered money. Even after age 69, he would only have to take the minimum withdrawal from a Life Income Fund (LIF) or a Locked-in Retirement Income Fund (LRIF). However, if he took the pension, he would be paying tax on the income even if he didn’t need it and would subsequently have to reinvest these amounts on an after-tax basis.

The moral of this story is that an individual has to place their pension decision in the context of their overall financial planning, rather than as an isolated decision.

If a portion of the member’s pension is coming from an unfunded supplemental plan, then the analysis becomes even more interesting! The member now has to factor in the risk of the financial failure of the plan sponsor and the subsequent loss of income. In addition, the lump sum payable from a supplemental plan is not tax-sheltered which creates another complication in comparing the relative values of the two options.

Past Service Buy-backs
Another example of this principle in action revolves around the issue of past service buy-backs. Pension plan members who have the potential to buy a substantial amount of eligible past service and then retiring need to know if this approach makes sense. The primary issue is to determine how the buy-back had been costed. If the member is being asked to contribute based on the current commuted value of the pension to be purchased, there is little value in proceeding. However, if the purchase price was based on the actuarial liability, this would include assumptions about issues such as:

• The rate of return
• The average retirement age
• The age of the member relative to the spouse

Given the right circumstances, where the member is retiring younger than the anticipated retirement age with a subsidized early retirement reduction and has a younger spouse, this could be an excellent way to obtain a guaranteed rate of return on RRSP investments.

Optional Forms Of Pension
Now consider the case of a couple in their early 60s. Their primary source of retirement income is the husband’s pension. He had retired a number of years before and they were living very comfortably. The husband had elected a level income option under his pension plan. Under this option, he was allowed to integrate his lifetime pension with the Canada Pension Plan (CPP) and Old Age Security (OAS) so that he would receive more pension before age 65 and less after 65. He was also entitled to a bridging pension which would stop at age 65. All together, I projected that his pension income would reduce by $20,000 per year at age 65.

Now, this might have been alright in some situations, where the couple had certain financial obligations which would be eliminated by age 65. In this case, there is no such planned reduction. Both partners had applied for their CPP at age 60. In addition, the husband’s OAS was likely to be substantially clawed-back because of his income level. It is clear that the couple has to either decrease their expenses by $20,000 per year or find some additional source of income. If they are some years away from age 65, they can take some remedial action. If not, reducing expenses may be the only choice.

This underlines the importance of counseling for any member who is thinking of taking a level income option.

When To Retire
The final example concerns a plan member in a contributory DB plan which provides subsidized early retirement reductions between ages 55 and 60 and an unreduced pension after age 60. Here, they want to know the retirement age at which they will obtain the best value from the pension plan.

This is no simple question. In full actuarial mode, calculating the present value of the future benefits less the present value of future contributions, corresponding to each possible retirement age, gives almost any answer for the optimal retirement age between 55 and 60 simply by adjusting the assumptions about:

• Future rates of return
• Member and spouse life expectancies
• Level of future salary increases
• Future rates of inflation

The moral, as usual, is that it would have been much more useful for the plan member to look at this situation in the context of the things that they want to do with the rest of their life and the financial resources that they and their spouse have available.

What I have discovered in the work I have done to date is that:

• There are few ‘average’ people
• Most of them have some unique attributes which will influence their financial decisions
• These issues are not self-evident, education is required
• Given the significance of the decisions being made for the future well-being of the individuals, it is worth the time to analyze the outcomes in the context of their overall vision of retirement and the other financial resources they have available

Patrick Longhurst is president of Patrick Longhurst Advisory Services Inc.

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