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The following is a guest post by financial planner, author and pension expert Alexandra Macqueen, which originally ran on Dale Roberts’ Cutthecrapinvesting blog on Feb. 26, 2020. Because they both consider it such an important subject, they have given us permission to re-publish on the Hub. While an overview, it can serve as the ultimate guide to defined benefit pension planning. And mostly, Alexandra outlines the pitfalls and the importance of finding a true and qualified pension expert.
By Alexandra Macqueen, CFP
Special to the Financial Independence Hub
If you’re a Canadian facing a decision about staying in or leaving your defined-benefit pension plan, it might be one of the highest-stakes choices you’ll ever make: the amounts you’re considering can be high – worth as much as your house, or even more – the timeline short, the tax consequences significant, the details complex, and the outcome irreversible.
Over the course of my financial planning career, I’ve encountered, unfortunately, more than one pension decision gone wrong. Just how many ways can a pension decision go off the rails? Here are five “pension pitfalls,” drawn from real-live cases that have crossed my desk in the last year or so, along with the lessons Canadians who are facing this decision can glean.
Pitfall Number 1: Unbalanced advice
It is widely understood that defined-benefit pension plans cover what’s called, in the financial planning world, “longevity risk” – or the chance of living longer, even much longer, than you expect. Defined-benefit pension plans protect against the risk of living very long by providing lifetime income.
In exchange for covering off this risk, however, if you die sooner than expected, the pension payments may stop (depending on whether you have a surviving spouse or other beneficiary, and whether your plan provides guaranteed payments for a specified term).
One of the most misleading financial plans I ever encountered – it was just one page, and written in Comic Sans font – outlined the “pros and cons” of staying in a defined-benefit plan. Under “cons,” the planner had listed “mortality risk,” which they defined as the risk of dying relatively shortly after starting to receive monthly pension income.
Here’s what they meant by “mortality risk:” Let’s say you’re facing a pension decision between, say, receiving a lump sum of $750,000 if you “commuted” your entitlement under the plan today, versus $3,500 per month for as long as you’re alive – and you’re wondering about what happens if you die a few years after starting the pension. (“Commuting” your pension entitlement means taking the assets out of the plan as a lump sum today, typically to manage on your own.)
In this situation, and with “mortality risk” presented by the advisor in this way – as equally balanced with the probability of living a long time – it can be very tempting to think that the best option is to “take your money and run.” Maybe you’ll die “early,” you might think – and if you do, you’ll leave an estate!
However, this “financial plan” simply listed “pros and cons” of staying in the defined-benefit plan, without considering the probability of either outcome. If we use the projection assumptions provided for Certified Financial Planners® to reference in preparing financial plans, we can see that a woman aged 65 today has a 50% chance of living to age 91, and a 25% chance of living to age 97, while a man aged 65 today has a 50% chance of living to age 89, and a 25% chance of living to age 91 (see page 13 of the linked document).
Longevity risk vs mortality risk.
Instead of this guidance, however, in this plan the chance of “living” (longevity risk) and “dying” (mortality risk, although you won’t be able find anyone else using this term in the way this advisor did) were presented as equally-weighted possibilities, with no discussion of the likelihood of living to an advanced age.
While a discussion of the impact of dying “early” on pension outcomes is appropriate, this probability should be contextualized – not simply listed as a “con” of staying in a defined-benefit plan, and implicitly characterized as “just as likely” as living to an advanced age.
Pitfall Number 2: Inexpert advice
In this case, a member of a “gold-plated” pension plan (think large sponsoring organization and top-of-the-line pension plan features, such as inflation protection) was going through a divorce, and needed to find a way to equalize assets with a soon-to-be-ex-spouse.
As is not unusual for members of defined-benefit pension plans, the member didn’t have significant other assets. In order to meet his financial obligations, and guided by a financial advisor, he decided to commute his plan entitlement and use the freed-up cash to make an “equalization payment” to his ex.
Unfortunately, neither he nor the advisor really understood the tax consequences of this choice. Because of the size of the plan’s commuted value, the client was unable to shelter much of the paid-out lump sum from immediate taxation, meaning he had a very significant tax bill when tax time rolled around. (That’s because the amount of the commuted value was well in excess of the Maximum Transfer Value set by the Income Tax Act, which specifies how much of that commuted value can be sheltered from immediate taxation.)
Hello tax bill, so long pension.
However, by the time the tax bill hit his mailbox, he’d already transferred an equalization amount to his former spouse – an amount that had been calculated on the pre-tax commuted value, not the after-tax amount that was actually available to share.
After the dust settled, what the client was left with was a huge tax bill, to catch up on the tax due on the withdrawal; no more pension to rely on for retirement income; and, thanks to the immediate tax owing, a severely-depleted pool of assets to generate retirement income.
The worst part of this story is, however, yet to come: Under changes to Ontario’s Pension Benefits Act that came into force in 2012, the plan member would have been able to transfer his former spouse’s entitlement to her directly from the plan with no tax consequences. The financial advisor in this case – who stood to benefit from the deal if they got the commuted assets to manage – presumably didn’t know this option was available.
No professional designations, no recourse.
The plan member, for their part, didn’t seek any other advice until they were confronted by a six-digit tax bill they weren’t anticipating. That’s when they got the news (from a lawyer who specializes in working with the unhappy clients of financial advisors) that because the advisor had no professional designations, just sales qualifications, there probably wasn’t a successful legal action to take: the advisor had no duty to provide advice in the “best interests” of the client, meaning the outcome of any legal action would be “a crap shoot.”
Pitfall Number 3: Incomplete advice
If you’re a member of a defined-benefit pension plan and looking around for advice on whether to stay in your plan or commute your entitlement, the “average” retail financial advisor – and the “average” financial discussion on this topic published in mainstream media – will usually suggest there are essentially two options: commute your entitlement (perhaps accompanied by a large tax bill) and manage various risks (market, “sequence of returns,” longevity, inflation) yourself, or stay in the plan (and take your chances if you’re worried about plan solvency over your lifetime).
However, in many, if not most cases, there’s a third option: commute your plan entitlement to a “copycat annuity,” or a life annuity from a Canadian insurance company that matches your rights and benefits under the plan, including the monthly pension income.
For a while, I was pointing out this “missing advice” on Twitter when I saw it in the wild, but I stopped when it seemed like I was never going to get a break from harping on this point.
Copycat annuity option.
In a nutshell, a copycat annuity can provide security of retirement income for someone who doesn’t want to leave the “defined-benefit” environment of a DB plan, but is concerned about the long-term prospects of their counterparty in the pension promise. (That is, will the company, and the pension plan, be around to pay out for as long as you need it to?) This option can provide the security of a well-capitalized lifeco and an income stream insured by the backstop of Assuris, which insures the monthly income provided by an annuity if the issuer fails.
The point here is not that a copycat annuity is the right solution for any worried pension plan member, but that plan members need and deserve to know all of the available options! If you were facing a “stay-or-go” decision worth five, six, or even seven figures, and you were seeking guidance from an advisor – wouldn’t you want to know about, and carefully consider, the full range of choices you had available?
Pitfall Number 4: Misdirected advice
Many years ago, a business coach asked me, “Do you drive by looking in the rear-view mirror?” (Of course not, I responded; because then I’d crash into the things that were right in front of me, distracted by looking only at where I’d come from, and not where I was going.)
The same pitfall can arise in assessing whether to stay in a defined-benefit pension plan – or take your money and run.
Case in point: I’ve listened to more than one seminar providing advice about how to decide whether a company-funded defined-benefit plan is sustainable over the long haul that hasn’t provided any forward-looking guidance about the long-term prospects for the plan. (Forward-looking indicators: think plan solvency ratios and how to understand them.)
Instead, the presenter has focused on whether a plan has historically made the payments promised to pensioners, and suggested this is an appropriate and relevant metric — and perhaps even the most important metric — for future retirees considering whether to remain in a DB plan or commute their entitlement.
This viewpoint presents exactly the same difficulties as navigating your car using only the rear-view mirror, and it’s why everything from index funds to managed accounts include a version of the disclaimer, “Past success does not guarantee future performance.”
Ask yourself: if a financial advisor told you that Sears Canada had historically made all of the scheduled pension payments to previous cohorts of retirees on time and as promised, would you feel that was sufficient guidance in helping you decide whether to stay in a less-than-fully-solvent pension plan from a company facing corporate bankruptcy?
What merit does knowing the “past performance” of the pension plan provide if the person providing the professional guidance is overlooking the current performance and likely future performance of the plan?
Pitfall number 5: Unsuitable advice
Until the last federal budget took this option off the table, members of defined-benefit plans could sometimes commute their plan entitlements to “Individual Pension Plans.” IPPs are one-person defined-benefit plans that are set up when the employee retires, sets up a new corporation, becomes an employee of that corporation, establishes a defined-benefit individual pension plan for themselves as an employee, and transfers the commuted value of their entitlement from their previous job over.
That’s what a retiring Ontario Hydro employee did back in 2008. Just two years out from full retirement, she commuted her Ontario Hydro pension entitlement to an IPP she set up. In making this decision, she relied on advice from financial advisors who, she says, assured her she’d get more money out of the IPP than she would if she stayed in the Hydro One pension plan. These advisors would help facilitate the transfer and manage the commuted assets within the IPP, naturally.
Shortly thereafter, however, the wheels on her IPP bus came off, as she was not only not receiving the income from her IPP that she expected, but people around her (starting with her bookkeeper) began to suggest that the IPP she’d set up was unlikely to pass muster with the Canada Revenue Agency.
In order for an IPP to be accepted as valid – and thus the assets from the Ontario Hydro pension plan transferred to the IPP on a tax-deferred basis – the IPP must meet a series of tests, the most important of which is the “primary purpose test.” That is, the IPP, like any other registered pension plan, must be primarily established to provide periodic payments to an individual or individuals after retirement and until death in respect of their service as employees.
We’ll see you in court.
Ultimately, the Canada Revenue Agency “de-registered” this IPP, as their review concluded the plan didn’t meet the primary-purpose test. That meant, in turn, the full amount of the Hydro One pension could be subject to full taxation in the year of transfer. Unsurprisingly, this case is now winding its way through the court system. (You can read the full details of the most recent decision here.)
In this case, an employee near retirement was advised to commute her secure defined-benefit pension in favour of a similar-sounding arrangement that was accompanied by a promise to pay more than the pension would have. As the court documents spell out, however, the promised benefits of the IPP in this case didn’t materialize, the employee ended up facing a tax bill she’d been assured wouldn’t arrive – and ten years later, she was still duking out the implications of that decision in court. Given a time machine, do you think she’d still make the choice to commute?
Avoiding pitfalls: Seeking balanced, expert, complete, appropriately-directed and suitable advice
There’s a lot that can go wrong in pension commutation decisions, and because commutation decisions are almost always irreversible, recovering from mishaps can be extremely difficult to accomplish. That’s why getting advice that helps you avoid these potential pitfalls before you pull the pension trigger is critical.
But how and where do you find this kind of advice? Here’s a basic, three-pronged rule: look for advisors who have designations, expertise, and no conflicts of interest.
All three elements are equally important. An advisor with multiple designations may not provide any better outcomes and advice if they’re still missing experience and are working from an inherently-conflicted point of view (i.e., they stand to benefit directly if you commute your pension and they get the assets to manage).
Instead, what you want is someone who has experience guiding clients through pension decisions, and is highly knowledgeable about pension issues generally – including the plan documents themselves, as well as all of your commutation options, the tax consequences of commuting, and any other relevant factors (such as family law issues). If the situation places them in a conflict of interest, in which (as defined by FP Canada in the Standards of Professional Responsibility for Certified Financial Planners) the advisor’s interests “may adversely affect their judgement or obligations to a client,” the advisor should require the client to get objective advice, as discussed on Twitter here.
Pension decisions are all unique and always complex.
But perhaps the most important of these three qualifications is the requirement for expertise. Pension decisions are complex. Each pension is different, and each person is different. Make sure you get advice from someone thoroughly qualified to provide it: as Red Adair famously said, “If you think it’s expensive to hire a professional to do the job, wait until you hire an amateur.”
Alexandra Macqueen is a CFP® certificant who can cut through complex financial problems to provide expert guidance. She regularly consults to businesses, organizations and other planners on retirement income planning, annuity analytics, and other personal financial topics. Follow her on Twitter at @moneygal. See also one of the most-read posts on Cut The Crap Investing: Pensionize Your Next Egg With Annuities, Your Super Bonds.
Excellent article. These are insights many advisors would not have the experience — or incentive — to provide.