Understanding risk in 2 key retirement planning decisions

When it comes to investing, investors understand risk and return tend to be connected – the higher the risk, the higher the return, on average.  Conversely, if you do not want any risk, you are essentially stuck accepting a risk-free rate of return, such as those offered by GICs.

Wouldn’t it be nice to get the return that goes along with risk, but while not taking the risk that is commensurate with that return?  In fact, there are a few cases where that is possible.  While risk is still being taken in order to generate returns above the risk-free rate, who is accepting that risk and who is getting that return is not always the same person, which can lead to opportunities for some.

Before I dive deeper into two such situations, let’s first define some of the key risk factors.

Understanding key risks for Retirees

When facing key decisions, retirees should consider the risk trade-offs inherent in their various options.  One key question that is often overlooked is who is accepting the risk in the first place.

While there are many sources of risk, retirees should be especially concerned about 3 key risk factors:

  1. Investment Risk (including Sequence Risk): This is the risk that average investment returns will be lower than expected, or that the sequence of those returns will not be favourable vis-à-vis the timing of your withdrawals.
  1. Inflation Risk: This is the risk that inflation will be higher than expected, thereby eroding your purchasing power.
  1. Longevity Risk: This is the risk of outliving your money due to a longer than expected life expectancy.

Below I have described two key retirement planning decisions where one should consider who is accepting the risk – the risk is present in either option, but who is accepting that risk is different.

Key Decision #1: Deciding between the pension or commuted value on a defined benefit pension plan

Many people are faced with the decision of taking the commuted value on their defined benefit pension plan or just taking the annual pension instead.  While looking at the potential return these two options can generate makes sense, one should also consider the risk trade-offs that occur in this decision.

Related article: Understanding your Defined Benefit Pension Options

While there are many risks, we will focus on 3: Investment (including Sequence), Inflation, and Longevity.

Who accepts these risks are summarized below:

RiskDeferred PensionCommuted Value
Investment Risk (including Sequence Risk)

 

The pension plan accepts this riskYou accept this risk
Inflation Risk

 

The pension plan may accept some, all, or none of this risk

 

You accept this risk
Longevity Risk

 

The pension plan accepts this risk

 

You accept this risk

 

 

Related article:  Should you take the commuted value on your pension?

One benefit of having a defined benefit pension plan over a retirement or investment account is that with the defined benefit pension – the plan is accepting the investment risk.  If returns are low, the plan sponsor generally has to top-up the plan.  Once you take the commuted value, you have to make the investment decisions (or hire an advisor), and you also have to accept the investment risk yourself.  If returns are low, there is no plan sponsor to come in and top you back up.

Defined benefit pension plans may or may not have inflation protection.  Some plans have a tiered structure, where pension credits earned before a specific date are eligible for inflation protection and pension credits earned after that date are not eligible for inflation protection.  This is because the trend is toward less generous defined benefit plans, and fewer plans overall as well.  It really comes down to the specifics of each plan and each person’s credits to determine the level of inflation protection offered to them by their defined benefit plan.

However, determining the amount of inflation protection offered by the commuted value is simple as there is none – unless, of course, you put the entire balance in real return bonds or some other inflation-protected investment vehicle.

Another key benefit of defined benefit pension plans is that they pay benefits for life, no matter how long that life is.  With the commuted value, you are taking all the longevity risk.  You could potentially run out of money, especially if you live a longer than average life.  Fear and anxiety as you draw down your investments and get close to your last dollars would be avoided with a guaranteed income.

The biggest risk of the deferred pension is that you do not live a long life, and end up receiving less money through the monthly cheques than you would have received through the commuted value.  There is a break-even age at which these two options are equal, and that age is generally in your 80’s.  So, if you live past this break-even age, the deferred pension would have been better, and if you do not survive to at least the break-even age, the commuted value would likely be best.

In other words, the commuted value manages the risk of dying young, while the deferred pension manages the risk of outliving your money.

While you should certainly consider which option would provide the most money (i.e. the best return), you should also consider which option has the lower risk for you – because who accepts the risk that generates your return is not always the same under both options.  The deferred pension is usually a way of getting a return commensurate with risk-taking – but the plan is the one taking the risk and you are the one getting the return.  Whereas, with the commuted value, you still get the return, but are now accepting the risk yourself.

Key Decision #2: CPP/OAS and RRIF start dates

Deciding when to start your CPP and/or OAS is a top consideration for many people in or approaching retirement. 

Related article: When is the best time to start CPP?

A related decision is often what to do with your RRSP/RRIF (or LIRA/LIF).  For example, delaying your CPP/OAS may allow you to draw down from your RRSP at lower rates in your 60’s versus what you would pay after age 71 if you delayed the entire balance of your account until then.

While there are valid tax and other considerations to this decision, one should also consider the risk trade-offs that are inherent in this decision.  Who accepts the risks are summarized below:

RiskCPP/OASRRSP/RRIF
Investment Risk (including Sequence Risk)

 

Government accepts this riskYou accept this risk
Inflation Risk

 

Government accepts this risk

 

You accept this risk
Longevity Risk

 

Government accepts this risk

 

You accept this risk

In other words, the CPP/OAS represents government-guaranteed, inflation-protected income for life – no matter how long that life is.  Investments inside an RRSP/RRIF or LIRA/LIF, on the other hand, are much riskier to the retiree by comparison.

With this risk perspective in mind, you might prefer to drawing down on your RRSP / RRIF first because it is much riskier and you should want to manage your risks, especially these key risks retirees face.

Related article:  Developing RRSP withdrawal strategies

Also, it would give you an opportunity to defer the CPP/OAS.  Deferring your CPP from age 65 to 70 would result in a 42% increase in benefits (which is 0.7% per month of deferral) and deferring your OAS from age 65 to 70 would result in an increase of 36% in your benefits (which is 0.6% per month of deferral).  Those deferrals would essentially increase the size of your government-guaranteed, inflation-protected, longevity-risk-proof income.

Lastly, you would generally prefer to just get a monthly cheque at later stages in life than deal with managing your RRIF.  So, using the RRSP/RRIF to fund the earlier stage of retirement while deferring and therefore increasing the size of your CPP and OAS for later stages of retirement is another trade-off to consider.

Conclusion

While I have provided only two examples of situations where you should consider risk trade-offs of 3 key risks, there are certainly many more situations where you should go through this process and many more risks that may need to be considered as well.  Working with a qualified financial planner prior to making key retirement planning decisions is the only way to ensure your unique situation is fully considered.  Making such decisions within the context of a comprehensive financial plan is strongly recommended.

Comments

  1. Richard Urquhart

    I do not know how I got subscribed, but I do not know this information.

  2. James

    Great article ! Thanks

  3. Carl Melnyk

    Key Decision #1: Deciding between the pension or commuted value on a defined benefit pension plan

    Employers not honouring their legal obligations under thE acts and regulations which OSFI administers is an undeniable risk, significant because it’s getting to be a most highly probable situation. Topping that off are bankruptcy risks and this compounds all risks except with govco.

  4. Bill

    I am 7 years to go to 65.My only debt is a small investment mortgage. I am thinking to liquidate my RRSP position over this 7 year term to fully pay out mortgage. The rent I receive is going into TFSA account and at the end of the day the rent in TFSA and cash will equal the RRSP of today.This strategy will allow me to ease off my hours at work now to control tax burden, maximize my government pensions at retirement time with a large cash position and equity available in 2 properties that are debt free. Either property could be sold or not, let the market decide.Where is my unusual plan incorrect?

    • Ron

      In effect, what you are really doing is deleveraging. This isn’t a bad strategy if you are overleveraged and wish to derisk your portfolio , but you said this is a smallish mortgage. By paying off the mortgage, you will be decreasing your ROI, as a result of 1.) reducing leverage 2.) reducing deductible interest costs.

      When financial gurus tell you to make sure you have your mortgage paid off, they are talking about your personal home, not investments. Leverage is your best friend if used properly, especially in these low interest times. What’s really important is your bottom line, not the fact that you have a mortgage when you retire. Worst case scenario you have a property to sell to pay off mortgage. I retired with substantial loans for which I am in no rush to pay off. Doing so would not be a great investment strategy for me.

  5. KEN FORD

    If your planning on moving out of country, ensure you keep every piece of paper work related to your move. My wife was denied a CPP because the embassy in the Netherlands refused to sign or acknowlege her boarding pass on the plane, and CPP refused to release a pension without. CPP go out out of their way for loopholes and will no pay for paper work that cost you money, ie. a photostat at the embassy is $75.00 and they will not pay for these expenses even though they say they will cover federal costs.

  6. Ron Turnbull

    “The biggest risk of the deferred pension is that you do not live a long life, and end up receiving less money through the monthly cheques than you would have received through the commuted value. There is a break-even age at which these two options are equal, and that age is generally in your 80’s. So, if you live past this break-even age, the deferred pension would have been better, and if you do not survive to at least the break-even age, the commuted value would likely be best.”

    Utter nonsense and horrible advice to give anyone considering the commuting option. There is no breakeven age. You either beat the return, match the return or do worse. Even matching or doing worse could mean ultimately receiving more cash to you and your estate since the principal is yours to keep. This is NOT the same as CPP/OAS calculation for which there is a break-even number since there is no principal remaining when you die. This needs to be corrected.

    • Teddy

      Thanks Ron!!! You’re HIRED!

      • Ron Turnbull

        Why are penalizing me? I was just trying to help!

  7. Neil

    The article would make the DB pension or commuted value decision a slam dunk. But it spoke not all about the risk of the pension plan failing. Keeping your DB pension is like investing all of your capital in a single stock. That’s scary. So many pension plans are underfunded.

    Another consideration is early retirement. Often the payment is substantially reduced. If you take the commuted value you can at least control the drawdown.

  8. Janet Hudgins

    Would be very considerate of the gov’t to advise near-retirees to delay applying for CPP/OAS as long as possible to increase the income considerably..instead of carefully avoiding the subject.

    • Jeff

      Probably because you can’t assume one course of action is the right course for everyone! It doesn’t always make sense to delay CPP/OAS.

    • Ron Turnbull

      Janet, Jeff is correct, it really depends on your circumstances. Besides, not government’s job to tell you what to do with your money, unless you voted Liberal. I figure I would make more money over my lifetime if I delayed taking early option, based on my current health and personal circumstances. But instead I will opt for early payout. Why? Because having money when I am 60 is more use to me than it would be when I am 70.The break-even age would be at a time when I probably won’t be able to remember my own name. Remember, it Depends. (pun intended!)

      • Janet Hudgins

        I don’t know how I got here—Gremlins—but, I’m clearly in the wrong place, so adieu.

  9. Victor

    Jim, I saw somewhere that if you are under 71 you can take $2000 out of your RSP every year tax free. Is that true?

    • Brian Lorch

      You have to be 65. You have to convert your RSP to a RIF and generate pension income. And it depends on the province. The fed allows a $2000 deduction for pension income. Here in Manitoba, the pension credit is just $1000. So no fed tax but there is provincial for any RIF with drawl over $100.

  10. Deepak Thakkar

    I agree with the sentiment of the message related to DB plan. I withdrew mine and paid hefty tax on the commuted value close to 33% of the plan value. I felt the pain at the time. The decision that drove me to pull out was (a) Plan only assured 2.5% avg return over 20 years (b) No inflation increase in the monthly pay out (c) Once the plan has paid out 121 payment or 10 yrs and 1 month and primary member and spouse have died all money belongs to plan nothing comes back to estate as you do not own the capital in the plan just the member benefit. Once the member is gone and the spouse is gone there is no further benefits after 10 yrs…
    One more point about leaving the money of CPP and OAS till 71 is you run the risk of allowing the claw back at later stages when your LIF/RRIF min withdrawal percentage will push you over the limit of claw back for OAS

    • Mark

      Maybe I’m on the wrong track but I’m a firm believer that pensionizing as much of your nest egg is usually the best course of action. It mitigates the scourges of Longevity Risk and Sequence of Returns Risk. If you have valid reasons for doing so, and you make the decision to take the Commuted Value of your Defined Benefit pension plan, you need to counter the inherent risks that come along with making that decision. One way to mitigate those highly potential circumstance would be to withdraw more from your RRSP(s)/LIRA(s) or RRIF(s) in the earlier years. For example you could withdraw enough to take you to the maximum of the marginal tax bracket that you would be in even if you had not withdrawn the additional RRSP/LIRA funds. Invest the excess funds that are not required to maintain your chosen lifestyle in high quality growth stocks in a non-registered investing account. Then in the later years when your RRIF funds are no longer meeting your income needs you can begin using the tax efficient funds from your non-registered account to meet your needs. Remember, Capital Gains income receives much more favourable tax treatment than income from RRSP/LIRA or RRSP/LIF. Also, if taking the commuted value delaying your CPP and/or OAS should then at least be considered. Why? Because you have been depleting your other sources of income in the early years and if you suffer the negative consequences of Sequence of Returns those funds may have depleted a lot quicker than you had planned for (expected). By delaying CPP and/or OAS you not only mitigate Longevity Risk and Sequence of Returns Risk you now have more income to replace the lost income from your other investments. As well you are mitigating Inflation Risk on a lager amount of your annual income.

      • Laura Brown

        Are there composite options for DB/commuting? If there are, it seems to me, I would keep a percentage of my DB in the pension fund, which would give me a minimum living allowance, and then commute the rest so that I can leave something in a will if I die young-ish.

        Just wondering.

        • Ron

          No, it’s all or none. You could easily accomplish this yourself by taking an annuity for the part that you want to provide an income and invest the rest. Granted, the annuity will most likely not not provide you with the same terms as your pension, so you will take a hit there, if you want the flexibility you require.

      • Paul

        Agree with Mark. Unless you have a significant disability that would limit your lifespan then you need to plan to avoid the worst outcome in retirement vice maximizing the amount of money you receive. One outcome (delaying or keeping pensions) can be determined. The other, commuting or early benefits presents uncertainty. The worst possible outcome in retirement is running out of money when you can no longer generate funds through work. This can happen unexpectedly and suddenly through bad decisions or rolling the dice that your investments (which are uncertain) will produce a higher income than pensions.

    • Ron

      Deepak. Just to be clear for others. You didn’t pay tax on the entire amount. You paid tax on the excess of the Maximum Transfer Value MTV). And this amount depends on a number of factors, including age and time in pension, etc. Many people will pay nothing or only a nominal amount. If you paid alot of taxes, this means that you had a “plump” pension. In that case, because of the tax burden, you would need to calculate to see if it was worth it to commute.

  11. Deepak Thakkar

    My was a good DB plan plus I contributed to the upper limit that I was allowed which left me with no room to put money in RRSP. Still I was able to park some money from my cummulated portion to RRSP and paid 40% tax on the remaining. I still say leaving money in the pension plan take away so much freedome of your own money needs to be understood well before just signing the paper and handover your nest egg.

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