Here’s a scenario. The employee has non-registered investments and RRSPs with a trusted advisor, and a $300,000 commuted value in the pension plan. It’s likely that the investments have done very well recently(invested mostly in Canadian equity, income trust and balanced funds), and will have a three-year return well in excess of 12%.
The employee is married and about to retire. The pension plan will provide $1,860 per month for life, on a joint-and-two-thirds survivor pension. Let’s say there’s no inflation indexing on your plan, the member is childless and the pension plan is fully funded.
Many advisors might say: “The pension plan is giving you the equivalent of 7.5% on your money, but your RRSPs have just earned 13%,” attempting to persuade the employee to transfer their pension to a personal plan like a Life Insurance Fund(LIF). Hopefully, they have also said, “The monthly pension payments are guaranteed and the LIF payments are not,” but tempered that with: “Sure, there is some risk involved, but you’ve seen how [personal investments] have done. The good years make up for the bad.”
So the plan member comes to you with the intention of transferring. How can you help? Suggest that the employee and spouse consider these issues:
- The employee’s realistic risk tolerance. Have you ever watched people squirm through a two-year bear market as they withdraw 7% a year from their account and watch it steadily dwindle? Ask the employee how they felt the last time their portfolio suffered.
- Margin of safety. How does the family’s projected expense compare to the projected income? Are there excess investments and RRSPs that look like they will be kept in reserve? If cut close to the line, the security of the pension may be even more precious.
- How would the money be invested? The RRSPs could have been invested aggressively, as the guaranteed pension was a back-up plan. But investment science shows that investing more than 50% in equities while drawing capital each year decreases the sustainable withdrawal rate significantly. In a poor or uneven market, the pool of assets can dwindle even if the average return equals the withdrawal rate.
There are two problems here: conservative investments currently provide low returns, while volatile investments are dangerous places from which to draw capital. Thus, suggest to the employee that they ask the advisor for projections based on conservative investments, with a largely guaranteed omponent, to see if that still looks attractive.
- Unlocking. If the employee’s service has been earned in a province where pension money can be unlocked and withdrawn, has this been used as a selling point? Unlocking and spending capital can be very dangerous if the employee gets carried away.
- The math and science. Has an actuary determined the actual rate of return needed on the capital in order to sustain the same monthly income amounts as the pension? Annual or monthly fluctuations can wreak havoc with the principle amount, even if the average rate of return hits the target. Ask the employee how long they hope to live to prevent a cash crunch.
The right reason to transfer out a pension is that the employee’s number one objective is to maximize estate value, usually for children. An alternative way to provide an estate is the purchase of permanent life insurance. The financial advisor might be pleased to explore this, but proper advice on that requires the same rigorous evaluation as the pension transfer decision.
An employer is in an awkward position, but has an obligation to warn employees about the risks of transferring a pension to a private plan. Develop a series of questions to ask the employee and the advisor, to ensure the choice is the right one.
Beasley Hawkes is a pseudonym. He is a practising financial advisor and a columnist for Advisor’s Edge. advisorsedge@rmpublishing.com
