Wednesday, 15 March 2017

Pension Dilemma (or Opportunities Abound!)

For someone facing the choice of receiving a fixed monthly pension income from a company or in the form of an annuity from an insurance company, versus receiving a commuted value and having to invest the amount oneself does present a dilemma.

Let’s look at the details using some very realistic numbers assuming one is indifferent between monthly pension income or annuity.

Monthly Pension or Annuity (Option 1)
Commuted Value (Lump Sum) (Option 2)
Amount per month
$600 fixed, guaranteed for 5 years
$130,000. Invest conservatively in fixed income to yield 4% or $433 per month
Principal remaining at end of life
Monthly amount
About $167 more than option 2
Guaranteed by insurance company for 5 years, or in the case of private company pension, guaranteed by PBGC
Default risk if company goes bankrupt. Can opt to invest in Government of Canada bond, but yield 1% less . Also face reinvestment risk if rates are lower. However, rates are at historic lows and can only go up.
Ancillary benefits
Some companies may tie in health benefits with monthly pension
May forgo health benefits if opt for CV
Dependents/(or surviving spouse)
Monthly benefits may be reduced (assuming company pension and opting for Joint and Survivorship).

If opting for annuity, once guaranteed period ends, $0 for dependents or surviving spouse)
Dependents or surviving spouse can inherit the principal balance if included in will
Taxable income; annuity may have some tax advantage
Taxable income or capital gains at a lower rate
Life expectancy
Based on mortality tables, would be advantageous to receive monthly amounts if expected to live a long life (above 80 years of age)
Not applicable

So what is the conclusion? It all depends on the person’s situation. If I were a betting person, have a spouse or dependent, and can tolerate some risk, and assuming that we are in a historically low interest rate environment, I would choose Option 2.  I would choose to accept a lower income now, wait for rates to go higher (or at least above the $600 per month in Option 1), and then invest the whole amount and obtain more than $600 per month in later years. When I pass on (hopefully many years later), my surviving spouse or children can still inherit the principal amount of $130,000.

If one is in need of income and also cannot tolerate any risk, then choose option 1.  Mind you, in addition to this pension ,there are also other government benefits such as CPP (current maximum per month -= $1,114.17 at January 1, 2017) and also OAS (current maximum per month -= $578.53 at January 1, 2017)

There are other options that I can think of, but for now, I do think that this opportunity warrants further discussion with your financial advisor before making a decision. Because rates are at historically low, and we are starting to see the U.S. Federal Reserve Bank beginning to hike interest rates, CV or lump sum payouts may never be this high again and one can reinvest the CV or lump sum to one’s advantage.

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