Unique opportunities sometimes come in extreme times.
The one detailed below on commuting the value of your pension won’t be an option for many, but for those with the ability to take advantage, it could meaningfully improve their retirement finances for years to come.
This opportunity is based on three fundamental facts.
First, the current or commuted value of your pension is much higher when interest rates on 5 Year Canadian Bonds are low. The five-year bond is trading near historic lows, at 0.57 per cent at the time of writing.
Secondly, you can use the paid-out pension money to buy some very solid long-term Canadian investments with dividend yields of six per cent or more.
Finally, the effective marginal tax rate on Canadian dividends is very low. In Ontario, British Columbia and Alberta, you don’t pay any tax on such dividends at $40,000 of taxable income, and only 7.6 per cent at $70,000 of taxable income.
Let’s take a look at each of these facts.
Why low interest rates make your pension worth more today
This only relates to the one-time value of defined-benefit (DB) pension plans, since defined-contribution plans go up or down in value each month based on the investment value of your account.
Low interest rates can be great for DB plans because they are valued on a specific date — usually monthly. This value is essentially meant to compensate you for what the pension would need to set aside to cover your pension payouts.
Let’s say you needed to get $50,000 a year from a guaranteed investment certificate. If interest rates are 10 per cent, you would need $500,000 invested to generate the $50,000. If interest rates are one per cent, you need $5 million to generate the same amount. Today, the pension plan needs to set aside much more money to ensure it can meet the fixed needs of your lifetime pension.
The value of your pension is made up of several factors. Needing $5 million to generate $50,000 is a very generic example, but the difference could mean getting $250,000 or more on a full mid-level pension if you retire today compared to if you retire when rates are two percentage points higher.
Of particular interest is that pension plan managers do not want you to take the commuted value. They don’t want to lose assets at the best of times, but especially not at the most expensive times when interest rates are low. If they wanted you to take out the cash, they would provide more education to make your decision easier. In our experience, you often have to push hard to get answers to key questions that might help you make better informed decisions.
Keep in mind, too, that with some plans you can make the decision to take the cash instead of the pension right before you retire. With other plans, you have to make the decision to take the commuted value of a pension as early as age 50 or 55. This is an important question to ask your manager.
What to do with a cash payment
One of the keys to making such decisions is to understand that this isn’t play money. This is your retirement pension. You want to invest wisely and lean conservative. If a portfolio won’t do as well as your pension, then you should keep the pension.
We often analyze pensions for clients to determine the break-even point if someone was to live to be 90. This point will depend on whether a pension is fully indexed to inflation, and must account for any other health benefits that might be included.
Having said that, because of the low interest rates at this time, the rate of return required to do better than a pension payout is generally in the range of 2.75 per cent to four per cent today. If the pension funds are invested at, say, a three-per-cent annual return until age 90, and funds are drawn out exactly the same as they would be in a pension, the investments will be worth zero at age 90, the same as they would be for the pension if you pass away at 90 with no survivors.
Over the long term, three per cent is a pretty low hurdle to clear. It is much easier now. As an example, we put together three investments with a combined yield of more than seven per cent that could help you achieve this return.
George Weston Preferred Share – Series D: The current dividend yield on this fixed-rate or perpetual-preferred share is 6.2 per cent (at the time of writing). The share price is still down almost 15 per cent from March, but we believe that you will see some decent price recovery in addition to the dividend.
Canadian Imperial Bank of Commerce common shares: The current dividend yield is 7.5 per cent. No Big 5 Canadian bank has cut its dividend since the 1930s. It is possible they would, but very unlikely. The stock is still trading almost 30 per cent lower than it was in mid-February, but even if the stock price never goes up, and the dividend never rises, 7.5 per cent a year is a decent return. The good news is that both the stock price and dividend are very likely to meaningfully rise during your retirement years.
Bridging Income Fund: Bridging Income is a well-run firm that offers secured private lending and factoring. The fund has delivered consistent annual returns of eight per cent or more, with little correlation to stock markets. It has also provided positive returns for the past 70-plus months without a single negative month. We have worked with the fund since its inception seven years ago, and this has provided investment benefits to our clients.
The above three are clearly not meant to be an investment portfolio, but they represent a sample of what can be purchased today, often at higher yields than normal because of the decline in markets.
Tax and dividend considerations
Usually, the commuted value of a pension is paid out in two forms. The first would be funds that are tax sheltered and paid out into a registered retirement savings plan or similar account. You don’t pay tax on the transfer, but you will pay full income tax on the funds when they are ultimately withdrawn from the account.
The second form usually comes out as a taxable lump sum. There is a maximum transfer value for a pension, with anything above this amount considered taxable income. The general rule is that the larger your annual income as an employee, the higher percentage of your pension payout will likely be taxable. There are some strategies to lower the tax payment, but it is important to fully factor in the tax bill when determining what pension option makes sense.
In the three investments mentioned above, the George Weston and CIBC investments pay out eligible Canadian dividends, while the Bridging Income payout is considered interest income.
For a pension payout, we would hold Bridging Income in a tax-sheltered account. For the Canadian dividends, we are very comfortable holding them in a taxable investment account, because of the low tax rates on this income. Even for someone who has a total taxable income of $90,000, the tax rate on Canadian eligible dividends is just 12.2 per cent in Ontario and 7.6 per cent in B.C. and Alberta.
One of the negatives of a pension is that you don’t have control of the cash flow. It comes in every month, fully taxed, whether you need the cash or not. If you take the commuted value of your pension, you have much more control over cash flow and income, and this can be very valuable over time, as shown by the Canadian dividend income example.
The bottom line is that historically low interest rates along with higher-yielding investments can be a very rare opportunity that comes out of unfortunate circumstances. If your company or organization is strong and you are very risk averse, then keep your pension as is. If you don’t fall into that group, you should at least explore your options, especially now.
Ted Rechtshaffen, MBA, CFP, CIM, is president and wealth adviser at TriDelta Financial, a boutique wealth management firm focusing on investment counselling and estate planning. email@example.com