Should Kathy take monthly payments or the commuted value of her pension?

Q. I am torn about making a key financial decision in my life. First, a little about myself. I worked for about seven years (actually, six years and 360 days) as a teacher in the Arctic. I resigned this year and have returned to the “south.”

Now, I have about a year to decide whether I cash out my federal public service pension plan or transfer the holdings into an annuity (about $93,000) and RRSP (about $71,500).

I have consulted with a financial planner at one of the large banks, who has made a seemingly convincing argument in favour of transferring the entire pension amount out. But I am well aware that I don’t know enough to be able to ask the right questions and make an informed decision. I am also aware the bank will benefit from my investment, as will my financial planner.

Can you give me some good advice on what I should do at this important juncture in my financial life?
–Kathy

A. I recently wrote an article on making the decision to keep your pension or take the cash, and you can read it here. But, in addition to offering the advice in that article I’d like to address other key parts of your query. For instance, you wrote: “I don’t know enough to ask all of the right questions.”

Kathy, here are a few questions to ask yourself, as well as your last employer:

1. Confirm when your pension income will start, the amount, and if it is indexed—meaning, will it increase with the rate of inflation.
2. If you were to commute your pension, how much of it would go to a Locked-In Retirement Account (LIRA) and how much will be taxable to you? If you have the RRSP contribution room, you will be able to move the taxable portion to your RRSP, so you need to confirm how much RRSP contribution room you have.
3. If you take a new teaching position down “south,” are you able to combine the pension from your previous employment with a new pension? You have almost a year to figure this one out, so there is no rush.
4. What is your life expectancy? If you have a health issue, it probably makes sense to commute your pension.
5. Are you a conservative investor? (I will touch on this further down.)
6. Do you want to leave an estate? A pension stops when you stop, and if you take the commuted value there may be money available to leave to loved ones.
7. Will you have other retirement income sources that will cover your basic lifestyle expenses in retirement? If so, then your lifestyle may suggest you commute your pension so you have access to more money in the earlier stages of your retirement.

When you visit your financial planner, he or she will likely do a comparison between your pension income and the income that could be generated from the commuted value. Ask your advisor to model this for you, and make sure you understand the model and assumptions used before making your decision.

To start the modelling process, ask your planner to show you the rate of return your investments need to earn to match your pension income, based on a specific life expectancy. Experiment with different life expectancies.

Now, you know the rate of return needed to match your pension income.

Ask your planner to show you the investment portfolio they recommend to deliver the required rate of return. Ask yourself if you will be comfortable with that investment portfolio. If it is too risky for you, ask your planner to model a solution with a more conservative portfolio and lower rate of return. What does the comparison look like?

When your planner models this for you they will make assumptions around inflation and investment returns. Ask your planner what rates of return they are using and why.

All planners make assumptions, but what are the right assumptions? If an investment return assumption is too high, then commuting the pension will look great; if too low a return is used, then the pension option will look best.

Ask your planner to use the rates of return recommended by FP Canada Standards Council on page 13.

Another thing to consider is the locked-in portion of the commuted value. With a federal pension, you will be able to unlock 50% of your LIRA at age 55. Ask your planner to confirm if the locking-in provisions will prevent you from drawing an income equal to your pension.

The final thing you should think about is how you will behave if you commute the pension.

A pension cheque comes in regularly and will continue for life, and most people will have no trouble spending the money.

If you draw a monthly income from your investments equal to your pension income, do you think you will spend that money just as freely as if it was coming from a pension? Do you think you might spend or withdraw less out of concern of running out of money?

What if the opposite happens and you spend all of your money in the first five years of retirement? Do you have enough self-control to make the commuted value last?

There is a lot to this decision, Kathy, and although I don’t have enough information to advise you. I hope these questions will help generate a good discussion between you and your planner. It also doesn’t hurt to talk to more than one planner if you are not sure.

Allan Norman is a Certified Financial Planner with Atlantis Financial Inc. and can be reached at www.atlantisfinancial.ca or [email protected]

This commentary is provided as a general source of information and is intended for Canadian residents only. Allan offers financial planning and insurance services through Atlantis Financial Inc.

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