In the last few financial freedom updates, I talked a little about my spouse leaving her full-time work. While there was a bit of financial juggling to do, there was one major decision that we had to make with regards to her pension. We had to decide on either leaving her defined benefit pension in place or taking the lump sum (commuted value) and investing it ourselves in a locked-in retirement account (LIRA).
Before making a decision on the defined benefit pension, about a year ago my wife also had a defined contribution pension that was transferred into a LIRA with Questrade. Transferring that pension was an easy choice as the benefits during retirement were not defined but based on investment returns. With the high MERs that the provider was charging, it was an easy choice to take the money and invest it myself. We decided to invest in low-cost index ETFs for that amount.
What is a Defined Benefit Pension?
First for new readers out there, a defined benefit pension is typically offered by government employers and is considered a major benefit of working for the civil service. In this type of pension, the requirement is that you work in government for 25-30 years, contribute a small portion of your salary towards the pension and in return, you get 60-70% of your working income during retirement (some pensions are even indexed to inflation). It really is a great deal for employees willing to stick it out with the same employer for the long term. More details about defined benefit pensions here.
The decision on whether or not to take the commuted value of a defined benefit pension is a bit more involved. Mostly because the income provided during retirement is defined and for the most part, secure. There is something about the certainty of regular recurring income that is enticing.
With any major decision like this, I like to review the pros and cons. For a numbers guy like me, there were also a number of intangible and subjective points to consider.
The Pension Numbers
Monthly Income for Life
I will admit that the numbers made a big impact on my decision. The pension statement showed at age 60 (about 22 years from now), my wife would be entitled to $7,700/year for life (not indexed to inflation). While not a huge amount during retirement, it would be a nice guaranteed base income. But also note that the $7,700/year includes the CPP bridge benefit. This means that the pension actually gets reduced at age 65, but CPP will kick in, so overall income should stay relatively the same.
The Commuted Value
When my wife left her job, she received some paperwork indicating her pension options. This included: leave the pension in place; transfer to a new pension (if applicable); or withdraw the commuted value of $54,500.
Due to the size of the commuted value, we had the option to transfer the full amount to a LIRA and avoid paying any taxes – at least until withdrawals begin in the future (55 is the minimum age in NL).
Comparing to an Annuity
A defined benefit pension is essentially the same as buying an annuity. Both will give you income for life, but you lose the balance once you pass away (some pensions and annuities allow the spouse to get a portion of the benefit).
Using an online annuity calculator, a 60 year old female buying a registered annuity provides about $5,000/year income for every $100,000 purchased. So to get an equivalent income during retirement, we would need to purchase about $150,000 worth of annuities to generate about $7,700/year income.
What rate of return would I need to turn $54,500 into $150,000 in 22 years (by age 60)? The compounded annual rate of return (CAGR) works out to be 4.71%. The DIY return required is likely less than this because the pension benefit gets reduced @ age 65, but we will leave that complexity out of this analysis.
So now the question becomes, do I think that a diversified low-cost passive ETF portfolio can at least match 4.71%? Historic long-term market returns show that returns will likely be higher than this. We also get the added benefit of choosing how much to withdraw from the portfolio and potentially, there is flexibility in how much money is left behind to the next generation.
While the numbers show that long-term market returns support taking the commuted value of the pension, there are other intangible factors as well that added to our decision. Some of these factors are specific to the NL pension.
- Removed health benefits – Some pensions allow pensioners access to medical benefits, which is a huge benefit for an aging pensioner. The NL government, however, has removed this benefit for those who do not retire with the government. In other words, if you leave government before retirement age, you will not be eligible for medical benefits even if you keep the pension in place.
- Control – If you didn’t know already, but when it comes to money, I tend to value control. With the commuted value, I can choose what to invest in, the amount to withdraw during retirement, and even use a lump sum if needed. Or, as mentioned above, we could leave a legacy for the next generation. The idea of the money essentially disappearing after I pass does not settle well with me.
A few readers have asked about their pensions and what they should do with them. I hope that this article helps in your own decision. If we had a federal pension that was indexed to inflation and provided medical benefits, then we probably would have written an entirely different article. In addition, if you aren’t comfortable with DIY investing, then leaving the pension intact is not a bad idea.
For me, it was a variety of factors that helped us ultimately make the decision to take the commuted value of the pension. The main reasons being: we can probably generate a higher income stream from the commuted value with 22 years of compounding at a higher rate of return; we can control the withdrawal rate during retirement which provides flexibility; and, the money doesn’t go away after my wife passes.
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