Pensions: lump sum or monthly payments?

Retiring employees or employees who otherwise leave their jobs are often faced with a tough decision to make regarding their employee pensions.

In many instances, companies will offer their employees the choice between taking their pension in a lump sum form or taking the pension in the form of a monthly pay-out.

Unfortunately, very little support is given to the employee to help them make this choice and as a result, much stress ensues. This is unfortunate given that the analysis can really be quite simple, if the right tools are used.

The Decision

So, is one better off taking the lump sum payment (if it is offered), or sticking with the monthly pension? While there are qualitative aspects to this question, the only way to truly come up with answer is to crunch some numbers. But before we get into any calculations, lets talk a little bit about what is actually going on here.

An employee’s monthly defined benefit pension option is fairly straight forward. The employee’s entitlement is based on a formula which takes into account the employee’s years of service, his/her average salary amount and some percentage amount (usually between 1% to 2%). This monthly amount is calculated to begin at retirement.

The lump sum option is a little more difficult to understand. Choosing this option means that the monthly pension is forfeited. The intent of the lump sum option is to give the employee what is known as the present value (or commuted value) of the monthly pension amounts that would otherwise be received. The calculation, which is usually made by an actuary, makes assumptions about life expectancy and inflation and uses a discount factor to determine what the lump sum equivalent should be. The lump sum amount is meant to represent the effect of receiving a lifetime worth of pension payments (from retirement to death) all at once.

But the question still remains, should one take the lump sum or the monthly pension?

The Number Crunching

No number crunching is required with regards to the monthly pension. The employee knows what this amount will be. And, since the plan is a defined benefit pension plan, the payment is guaranteed. Therefore, the only way the employee can be prepared to give up this monthly receipt is if the lump sum can provide for a greater pay out. Hence the need for some numbers to be crunched.

An Example

Mr. X, an Ontario resident with an Ontario regulated pension plan is 55 years old and is five years away from retirement. Due to a downturn in the economy Mr. X is losing his job. His employer has given him a choice. Collect an annual pension of $21,600 beginning at age 60 or receive a lump sum pay out of $200,000 immediately. Assuming a life expectancy of age 90, we need to determine whether the lump sum amount can provide a better annual pension than $21,600 a year.

Since Mr. X would not collect his pension for another 5 years, we will assume that the
$200,000 will be left alone and could therefore compound during this time. It is important to note that pension regulations mandate that the money must be transferred to a Locked-In Retirement Account (LIRA). At a 7% rate of return, the lump sum would therefore be worth $280,000. In order for Mr. X to begin withdrawing monthly amounts, the $280,000 must be transferred to either a Life Income Fund (LIF) or a Locked-In Retirement Income Fund (LRIF). Using a LIF calculator (For example in Financial Navigator) will help us determine what the maximum LIF payment would be and how long the funds would last. At a 7% rate of return and assuming a CANSIM rate of 6%, Mr. X’s maximum payments would average approximately $20,000 a year till age 80. At age 80, $180,000 would be available to purchase an annuity.

Therefore, the break-even rate of return in this analysis is roughly 7%. If you feel you can achieve a rate of return higher than 7% (given your risk preferences), the lump sum would be a more attractive option. If you are a risk averse investor and are not willing to take on the risks associated with aiming for a return higher than 7%, the pension would be a more attractive option.

Note that the CANSIM rate is a discount factor (which is tied to the prevailing federal government long-term bond rate) which is used to establish LIF maximum payouts.

The Decision is also Qualitative

So the question now becomes whether or not it makes sense for Mr. X to go the route of the lump sum payout? It is at this point that we need to consider the qualitative aspects of either choice.

Pension – Positives

The pension is guaranteed. This is a big positive as far as the “sleep factor” is concerned. The pension may also be indexed which in many cases is the full increase in the Consumer Price Index (CPI). The pension may provide benefits such as medical, dental and term insurance.

Lump Sum – Positives
Lump sum pensions are much more likely to create an estate value. Until age 80, if Mr. X passes away, the LIF becomes unlocked and can therefore be passed on to his beneficiaries. If Mr. X used an LRIF, no annuity is needed to be purchased and so when Mr. X passes away (even if it is past age 80), the LRIF becomes unlocked and the remaining balance can be passed on to his beneficiaries. On the other hand, the pension option most likely will not leave an estate value. (The only way a pension would leave an estate value is if there is a ‘guarantee period’ and Mr. X dies within that ‘guarantee period’.)

Conclusion

The decision to take the lump sum value of your pension or the monthly payments can affect your financial security for the rest of your life. It is important to take the time to consider all the important variables, such as rates of return, life expectancy and personal estate planning issues.

Contact us at (604) 535-4749, or use our contact page.

Life Annuities

Are They Right for You?
As a part of retirement planning annuity income can compliment other incomes you are receiving. There are two types of annuities – “life” and “term certain.” Both these types of annuities can be registered and non-registered. This article will outline the details of life annuities and suggest reasons why you may wish to consider them in your portfolio.

What is a life annuity?
Life annuities provide you with a regular income paid at selected intervals for the rest of your life, regardless of the age you live to. These payments will cease at your death and no value will be available to your beneficiaries unless you arrange for a joint annuity or a guaranteed minimum payment period (explained later.) These regular payments can be monthly, quarterly, semi-annually or annual. A life annuity can only be purchased from a life insurance company. The income payments can be level for the remainder of your life or can be indexed at a pre-selected rate. Several factors, including current interest rates, are considered when an annuity income is calculated, and as a result, once you buy a life annuity you are locking this interest rate in for the entire payment period.

Registered
Life annuities can be purchased with assets in any registered account. (These can include RRSP, RRIF, LIF, LRIF and DPSP funds.) You can also arrange for your company “Registered Pension Plan” to be converted to a life annuity. The entire amount of the income you receive will be taxable in the year you receive it.

Non-registered
Any money you have in an unregistered account may also be used to purchase a life annuity. The taxation of payments from a non-registered annuity can be quite favorable. Non-registered funds can be used to purchase a “prescribed” annuity. When you do this only the interest portion of the payments are taxable and this interest portion remains level throughout your lifetime. This results in a very favorable after tax income. A suggested strategy would be to consider using cash that is in an account and earning interest, which is taxable to you each year, to purchase a prescribed annuity. The resulting after tax cash flow will be substantially greater. If you wish to ensure that the original capital you put into the annuity is available to your beneficiaries (remember the annuity stops at your death) then you can life insure this capital. In most case, even after the cost of insurance is paid, the remaining after tax income is significantly greater.

Types of life annuities

“Single” life annuities

These will pay you an income at the selected intervals for as long as you live. As mentioned the income will cease at your death.

“Joint” life annuities

These will pay an income for as long as two people live, the income will stop at the second death. Typically you would select this type of annuity to be sure you and your spouse would receive income for life. As a note, current pension legislation requires that if you are married and are selecting an annuity income from any registered pension plan, you must select a joint annuity with your spouse. The only exception to this would be if your spouse “signs off” and allows the payments made for your life only. In most cases it would not be in the best interest of either spouse to sign off as this effectively “disinherits” the survivor. Joint life annuities can also be arranged to pay the original amount, or a percentage of the original amount, to your spouse after your death. Typically this would be 75, 60 or 50%.

Guarantees

Although all life annuities will pay an income to you for the remainder of your life, this income will cease at your (or the joint annuitants) death. In order to protect you against a substantial loss in the event you purchase an annuity and die within a short period of time, you can add a minimum guarantee to the payment period. This can usually be 5, 10, 15, or 20 years or until a specific age. The maximum guarantee period however cannot exceed your age of 90.

Example: If you add a 10 year guarantee to a single life annuity and die in the 5th year, the remaining 5 years of payments will be commuted to a discounted lump sum and paid to your beneficiary.

How do you decide?

The income received from a given amount of capital will reduce as you add additional guarantees and survivor benefits to an annuity. The highest income will result from a single life, no guarantee annuity. This income will reduce as you add features to the point where the least amount of income would result from a joint last-to-die annuity, with a maximum guarantee period, paying 100% of the original income to your spouse at your death. When you are considering which type of annuity is best in your situation you should review several quotes with these various alternatives. This will allow you to see the resulting incomes, and help you select the correct annuity, based on your income requirements, balanced with your desire to leave an estate for your beneficiaries.

Impaired annuities

Similar to the effect poor health will have on the purchase of life insurance, in that it will increase the premium you pay, the effect of poor health on life annuities will be to increase the income you receive.

When should you consider life annuities?
For most people a “base” income that is guaranteed to be paid for your and/or your spouse’s life can form the foundation of retirement income. Here are some factors you might consider in purchasing a life annuity.

• You want a fixed income guaranteed for life.
• You don’t want to make investment decisions.
• You want to lock in your investments at current rates.
• You’re not concerned about leaving an estate to your children or grandchildren.

Summary

The use of life annuities can bring several advantages to your income planning. As with any other decision, assistance from The Butler / Laing Group in showing you how these can fit into your plan would be of benefit. In addition, rates from different insurance companies can vary significantly and we will be able to assist you by shopping various companies and reviewing the results with you.  Contact us at (604) 535-4749, or use our contact page.