Pension vs. Commuted Value: To Transfer or Not to Transfer?

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1 Pension vs. Commuted Value: To Transfer or Not to Transfer? The University of British Columbia Staff Pension Plan (the "Plan" or "SPP") is designed to provide you with support in retirement. It will not be, and should not be viewed as, your only source of retirement income. Once you've been in the Plan for several years, however, your UBC pension can make a substantial contribution to your retirement security. When you leave employment with UBC, you have choices to make with respect to your Plan benefits. This article examines the choice between drawing a monthly pension from the Plan and transferring the lump sum commuted value of your benefit out of the Plan. While some of the following information may apply to other retirement arrangements, please note that this article has been written specifically for members of the SPP and much of the information applies only to the SPP. Pension Option Electing the Pension Option means you choose to keep your money in the Plan and receive a monthly pension payment from the Plan for the rest of your life. There are several benefits and choices associated with the Pension Option: Typically, the pension would start at age 65 (the "normal retirement age"). If you choose to retire early, the amount of your pension may be reduced to reflect the fact that you'll be receiving the pension for longer. You could also choose to delay pension commencement beyond age 65. The pension paid from the Plan is increased annually for inflation both before and after pension commencement. Your beneficiaries are entitled to death benefits, whether you die before or after pension commencement o If you die before your pension commences, your spouse would get a benefit equal to the value of your pension, paid either as a lifetime pension or as a lump sum transfer. If you have no spouse, your beneficiary would be entitled to the lump sum transfer. o When you are ready to start your monthly pension, you must choose your form of pension payment which determines your post-retirement death benefits. The standard post-retirement death benefit is a 10 year guarantee, which means that your pension is payable for the rest of your life, and for 10 years in any event. You can choose from several other pension forms, such as providing for 60% of your pension to continue to your spouse after you die for the rest of their lifetime. When you leave UBC you will receive a package outlining all your options including the monthly pension income you can expect. If you have questions about early or postponed Page 1 November, 2008

2 retirement, how the cost of living adjustments work, or the death benefits, you can contact the Pension Administration Office to discuss your personal situation. Commuted Value Option The commuted value is the amount of money invested today which would, under prescribed assumptions, grow to be exactly sufficient to provide the pension under the Pension Option above. Basically, if you get the assumed investment return, die when expected, and inflation is as assumed, then the lump sum commuted value will reproduce your SPP pension. The commuted value is calculated by an actuary or on a basis recommended by an actuary. Actuaries must follow the guidance provided by the Canadian Institute of Actuaries' Standards of Practice (the "CIA standards") for these types of calculations. In particular, specific direction is given with respect to the selection of assumptions to ensure standardization of commuted values across pension plans. In general a commuted value payment must be transferred to a locked-in registered vehicle 1, unless it qualifies as a small benefit under the pension legislation. The transfer does not affect your RRSP contribution room and the amount transferred is not considered taxable income. There are limits on the amount that can be transferred (and thereby tax-sheltered) and these are discussed in more detail later With this background, let's review the choice between these two options. The Assumptions Made The two options are theoretically equivalent. However, the commuted value is based on certain assumptions, which may or may not come true and electing the Commuted Value Option means you take on the associated risks and opportunities. Assumptions are made for future: 1. Mortality 2. Retirement age 3. Inflation 4. Investment return As mentioned, if these assumptions were all realized, the commuted value plus future investment returns could replicate the pension that would be payable under the Pension Option. However, individual circumstances can vary widely. Let's have a look at how these assumptions might influence your choice. 1 A "registered vehicle" could be a Registered Retirement Savings Plan ("RRSP"), a Life Income Fund or equivalent, or another Registered Pension Plan. "Locked-in" means the funds must be used to provide a lifetime pension. It is possible that a portion of your SPP benefit will not need to be locked-in. Page 2 November, 2008

3 The Mortality Assumption The CIA standards specify the mortality table to be used. The commuted value is intended to reproduce the pension for the person who lives the average life expectancy determined by the table. So, if you live longer than average, the lump sum may not be sufficient to pay your pension for your full lifetime. In this case, the Pension Option would have been a better choice, as it is payable for however long you live. On the other hand, if you die early, you or your beneficiaries may have preferred to have had the lump sum under the Commuted Value Option. If you take the commuted value, you are taking on the risk of outliving your pension. The Retirement Age Assumption The CIA standards require a commuted value be calculated using the pension commencement age that results in the largest value. For example, the value of a particular member's pension starting at age 65 is $68,000. But if the pension starts at age 55, the value is $70, The commuted value calculation therefore assumes the member retires at age 55 and $70,000 is available for transfer. If you select the Pension Option, you will want to at least consider starting it at the assumed pension commencement age, when the total value of the pension is projected to be the greatest. For the Plan, this is age 55, or your current age, if older. Of course, personal considerations would also impact your decision of when to start your pension. The Inflation Assumption The Plan currently offers inflation protection in the form of annual increases in pension equal to 100% 3 of inflation. In the commuted value calculation, a fixed inflation assumption is made. Annual increases to pensions-in-pay reflect actual changes in the adopted inflation measure (consumer price index). So, if actual inflationary increases in the pension turn out to be higher or lower than the assumed rate, the relative values of the Pension Option and Commuted Value Option change. The Investment Return Assumption The CIA standards assume that money invested today will earn investment return at rates consistent with long-term Government of Canada bond yields plus 0.5%. The actual rate assumed varies each month based on these bond yields. The calculations for indexed pensions use real return bond rates to infer the rate of inflation being projected by the financial markets. If you are in a position to take on the risks of a more diversified investment portfolio and thereby seek to achieve consistently higher returns than assumed, the Commuted Value Option may be attractive to you. However, with this opportunity comes responsibility. 2 Even though there is a reduction for retiring early, the commuted value is higher because the pension is paid earlier and for longer. 3 This percentage is subject to change. Please confirm the current level of indexing with the Pension Administration Office. Page 3 November, 2008

4 With the Pension Option, you do not take on any investment responsibility. You may prefer the Pension Option because of this convenience and security. Assumptions Summary The following table gives you an idea of how actual experience differing from assumptions might affect your choice: Assumption Pension Option may be better if: Commuted Value Option may be better if: Mortality Retirement age You expect to live longer than the average person You want to retire at the age assumed in the commuted value calculation You expect to die sooner than the average person You want to retire at an age different from that assumed in the commuted value calculation Inflation Inflation is higher than assumed Inflation is lower than assumed Investment return You're not sure if you can consistently earn the investment return assumed in the commuted value calculation You're confident that you can achieve consistent investment returns higher than those assumed in the commuted value calculation Your choice will depend upon a combination of the above considerations, your overall assessment of and willingness to take on the risks inherent in the Commuted Value Option and other circumstances unique to your personal situation. Plan Funding Status If you take the Pension Option, you are not, however, totally risk or opportunity free. The Plan has a unique design contributions to the Plan (both from members and from the University and other participating employers) are fixed. This means the level of your pension and your associated rights and benefits are variable, and depend on the status of Plan funding. If there came a time that Plan assets and future contributions were projected to be insufficient to fully fund Plan benefits, it may be necessary for future benefits to be cut back. The first place a cutback would occur is to scale back future inflation indexing (to less than 100% 4 of inflation). On the other hand, if there came a time that Plan assets were more than sufficient to fund Plan benefits, the Plan terms may require that benefits be increased. If you choose the Pension Option, you would be included in any cutback, and also in any future benefit increase. 4 As mentioned in Footnote #3, confirm the current level of indexing with the Pension Administration Office. Page 4 November, 2008

5 If you choose the Commuted Value Option the funds you withdraw are your responsibility as you are no longer a member of the Plan. You are not eligible for any future benefit adjustments (either decrease or increase). The Pension Board, with the assistance of the Plan's actuary, closely monitors the Plan's funded status with the objective of maintaining the balance between assets and liabilities, so that Plan benefits will be stable and paid to members as expected. In the 35 plus years of the Plan there has not been a benefit cutback nor a cash distribution. The Tax Equation The Commuted Value Option has Tax Advantages The primary advantage of investment through a registered vehicle is effective elimination of tax on investment income. 5 Therefore, the longer money stays in the registered vehicle, the longer tax-sheltered compounding works in the investor's favour. For employees who do not immediately need their SPP benefit for retirement income and whose objective is wealth accumulation through tax-deferral, the Commuted Value Option may offer a tax advantage. If the Commuted Value Option is elected, the money can remain to compound tax-free for longer, until age 71. In addition, taxation can be further delayed through your registered plan payout options. For instance, an increasing annuity pays out less initially and more later on, or you could vary your withdrawals using a Life Income Fund. And Disadvantages On the other hand, if the commuted value is greater than the amount that can be transferred to another registered vehicle, the excess is immediately taxable upon settlement of the Commuted Value Option. In this situation, any advantage of tax-deferral through transfer of the commuted value to an RRSP will be offset by the loss of tax-deferral on the excess funds. Be sure to pay attention to whether or not your options are affected by this limit. Locking-In Generally, most of the commuted value would be "locked-in" under pension standards legislation. This means that, after transfer to an RRSP or other registered vehicle, it must ultimately be used to provide retirement income, it remains subject to minimum spousal pension rules, and some investment restrictions may apply. Lock-in rules also apply to the Pension Option. Reinstatement Rights Only Applicable if You Elect the Pension Option 5 This may not seem intuitive since tax is eventually paid on all proceeds, including investment income. However, consider $1,000 of pre-tax salary, a 50% tax rate and 6% interest. Without a registered vehicle, $500 is invested after tax and earns 3% after tax on interest. The proceeds are $500 accumulated at 3%. With an RRSP, $1,000 is invested at 6% then 50% tax is paid upon withdrawal. The proceeds are 50% of $1,000 with 6% interest, which equals $500 with 6% interest. The main effect of the RRSP was that the 6% interest emerges tax-free. Page 5 November, 2008

6 If you terminate your employment, elect the Pension Option and are later rehired, your prior pensionable service can be "reinstated", in which case your ultimate pension is recalculated based on old service plus new service and the latest final average earnings. Election of the Commuted Value Option cancels any right to reinstatement. Making Your Decision This article addresses only some of the considerations you will need to ponder as you choose between the Pension Option (leaving your benefit in the Plan and receiving a pension at a future retirement date) and the Commuted Value Option (transferring your benefit out of the Plan and taking personal responsibility for your ultimate pension). There are, of course, other considerations that hinge upon your personal situation: financial considerations, tax considerations, family and lifestyle considerations, personal objectives, and so on. You will want to make your SPP benefit decision(s) in the context of your overall personal financial and tax situation. The choice is complex and while the impact of some the factors is easily quantifiable, the impact of others is not. You may wish to enlist the assistance of a professional financial advisor to help you. In choosing an advisor, you will want to ensure the individual is able to provide you with unbiased, professional advice. Some of the criteria you may wish to use as you select an advisor are: 1. Education The Certified Financial Planner (CFP) or Registered Financial Planner (RFP) designations are recognized Canadian qualifications which indicate a good base of education and training in financial planning. 2. Experience Advisors should have a reasonable base of experience, and build on that through ongoing focus on financial planning. You should expect a minimum of three years experience with financial planning as their primary vocation. 3. Compensation Financial planners work under a number of different forms of compensation including fee-only, commissions, fee and commissions, and other combinations. You may wish to seek a financial advisor who is compensated for financial planning services exclusively on a fee-only basis. Be particularly aware that if a financial planner is paid through commissions on investment or retirement income products, then that planner will get paid only if you take your money outside the Staff Pension Plan. A financial planner in that situation has a potential conflict of interest in advising you on these decisions. The Pension Administration Office is also available to help you clarify how the terms of the Plan apply to your situation. This article is for informational purposes only. It is summary in nature and does not constitute professional advice in any way. Page 6 November, 2008