We are often asked by members whether or not they should take their commuted value as a lump sum payout upon termination. Many of these members desire to have control over the investment of their assets and believe that they can outperform the returns offered by a defined benefit (DB) plan.
Our answer is that returns are only one part of the equation – and even if you are capable of consistently outperforming the DB plan over the long-term (which most people are not due to fees, lack of knowledge, tendencies to sell during tough times, etc.), there are other factors to consider including interest rate, longevity, and inflation risks, among others.
Looking back over the last 25 years, a period which has included some fairly long bull markets, one would never have imagined back then the extent to which a member who took a commuted value was exposing themselves to these risks. To illustrate the point, let’s look at a member who terminated employment in 1994 at age 30 with an accrued pension of $500 per month, payable at age 65.
Illustration – Member Takes Commuted Value 25 Years Ago
Back in October 1994, the commuted value would have been based on a 1983 mortality table and interest rates of 9.5% for 15 years and 6% thereafter. Fast forward to October 2019 and the mortality table is now a 2014 table that also reflects assumed future mortality improvements and the interest rates used have declined dramatically to roughly 2.5% per year.
The commuted value of our sample member’s pension in 1994 would have been $5,400. Should our member have withdrawn it at that time and invested the proceeds? Well, if they had left their pension in the plan and we were to re-calculate their commuted value now, it would be worth $84,700. This means that if the member had withdrawn the commuted value in 1994, they would have needed to earn 11.7% per year on that money – net of all fees – to equal what it would be worth today!
Of this 11.7% per year, they would have needed to have earned 10.9% to keep pace with the assumed growth in the commuted value and the decline in interest rates and the remaining 0.8% to account for the improvements in longevity due to the new mortality tables.
Was the 11.7% return, net of fees, achievable over the past 25 years? Well, if our member in question had invested in a 60% Canadian equity, 40% Canadian universe bond portfolio at the time of their termination, their annualized return over the last 25 years would have been about 7.7%. Not bad, but this is also before fees. This means that to equal the commuted value’s worth today, they would have had to outperform the balanced portfolio by over 4.0% per year for 25 years to protect against the changes in interest rates and mortality – it is a massive understatement to say that this would have been a tall order considering the factors mentioned above.
The Past is the Past – What about the Future?
Clearly, the above illustration would have produced different results in a rising interest rate environment, but that said, in a rising rate environment we would also suggest that achieving the 7.7% return using the sample portfolio would have been very difficult. The true value of a DB plan is that it accepts risks for its members; members are protected against interest rate and other risks and can rely on a steady income throughout retirement.
Going forward, do we expect the same interest rate and mortality environment as what we have experienced over the past 25 years? The simple answer is “no”. But we also would not rule out further declines in interest rates considering Canada still has some of the highest rates in the developed world. Needless to say, investing going forward and producing a reasonable rate of return will be more difficult then ever. A member making a decision on their commuted value will have to consider:
- Can I beat the underlying investment return assumption upon which my commuted value was determined? Given the current low interest rate environment, this might seem easier now than in 1994 when interest rates were close to 10%. However, risk would need to be taken to achieve this so the member would need to consider their individual risk tolerance.
- What kind of fees am I going to be paying to invest this money myself or with an advisor? And what kind of time and knowledge am I going to need to do a good job?
- Am I comfortable managing my longevity risk (i.e., the risk of outliving my assets)? Defined benefit pensions are payable for life, regardless of how long you live, whereas longevity risk can be difficult to manage for an individual (potentially leading to a significant reduction in lifestyle in later years as assets are drawn down).
- Do I have any personal health factors that might lead me to believe that I will not live as long as the average Canadian? If so, the commuted value may serve you better than the pension option.
- What is the likelihood of my employer going bankrupt? Our illustration would not apply if the employer became insolvent and there was no longer a “guarantee” on the deferred pension. This is, however, a risk that members of public sector plans probably don’t need to concern themselves with.
- What are the terms of the pension plan? Are there any provisions, other than insolvency, that could mean that the $500 deferred monthly pension could be adjusted (e.g., pre or post-retirement indexing, benefit adjustments – up or down – based on funded status, etc.)?
- What are the tax implications of taking the commuted value? The portion of the commuted value in excess of the Maximum Transfer Value is included in income in the year of transfer. For members close to retirement age, this amount may be significant and may make it more difficult to replicate the income from the DB plan.
In summary, when you receive your termination statement and compare your options, you will be faced with taking either a fairly large lump sum commuted value or a (perceived) tiny pension not payable for many years. Don’t assume that the commuted value is the best deal by default; it is important to consider your specific situation and risk tolerance before making a decision. Depending on these factors, it may make sense to consider leaving your money in the plan.
The commuted values were determined using unisex factors with a 50% male / 50% female assumption. The October 1994 assumptions were specifically:
- Mortality table: GAM83 (static table with no mortality improvement)
- Interest Rates: 9.5% for the first 15 years, 6.0% thereafter
For October 2019, the assumptions used were:
- Mortality table: 2014 Canadian Pensioner Combined Mortality Table with fully generational projection using Scale CPM-B
- Interest Rates: 2.3% for the first 10 years; 2.6% thereafter
For the return of the sample investment portfolio, we assumed monthly rebalancing between a 60% / 40% portfolio of the S&P/TSX Composite Index and the FTSE Canada Universe Bond Index.