Last week we met Shirley and her conundrum to either take the monthly pension income or move the lump sum out to a locked in RRSP known as a LIRA. This week, I want to share with you some very important considerations.
Rate of return
The first concern I have is the thought that Shirley's advisor can beat the rate of return on the pension. Defined Benefit plans are designed to be conservative. Typically, the investment mandate is a balanced portfolio of bonds, cash and stocks. Typically, the pension will keep 40% to 50% of the assets in very conservative fixed income investments.
Although her other portfolio made 14%, it is not a fair comparison because that portfolio was much more equity biased consisting of 90% common stocks, income trusts and dividend equities. Only 10% of that portfolio was in fixed income investments.
Investing for higher returns but with more risk is not always a good thing when drawing money out for income. Most people do not understand how big fluctuations in portfolios can wreak havoc on longevity of capital even if the average return is achieved. I've seen many cases where Locked in Retirement Accounts (LIRAs) have been mismanaged and in some cases over 50% of the value has dropped due to market risk.
Pensions are managed conservatively for a reason. Actuaries understand that guaranteed lifetime income is very difficult to achieve by investing in riskier assets. Be careful in thinking otherwise.
How long will you live?
Pensions last as long as you live no matter how long you live. Therefore, the longer you live, the more advantageous it is to choose lifetime monthly pension income. On the other hand, if you die too soon, you might be better off moving the money out of the pension so that assets can pass onto your heirs.
If you know your date of death, planning is simple. Shirley is healthy and does have some family history of longevity but unfortunately when it comes to life expectancy, it's all pretty much a guess.
Keeping up with inflation
When doing mathematical analysis on pensions, the biggest problem I see is that indexing benefit on pensions is ignored or grossly underestimated. In Shirley's case, her pension was indexed but her advisor failed to tell her that he would need to earn more than 14% once factoring in indexing.
Do you like to manage money?
Once pension income starts, there is no management required. You don't have to worry about markets going up and down, investing decisions, rebalancing or whether you will run out of money. This has a lot of appeal to Shirley as she does not have a lot of financial savvy.
In fact, according to Rein Selles, Professional Retirement Planner for Retirement Life Challenge, “Shirley, like most Canadians do not have the time, interest and/or inclination to manage capital so people should be very careful before moving money out of a defined benefit plan.”
Making this decision is not an easy one. If you are confused, you might want to seek help from a professional.
Unfortunately, most pension representatives are not allowed to provide advice as to whether you should or should not take your pension. As a result, pension members usually go to financial professionals to guide them through the decision making process.
According to Rein Selles, “This course of action can have some flaws because most financial advisors make money only if they get the asset to manage. Thus it is much better to pay someone a fee to do the analysis.”
For Shirley, moving money out of the pension may not be the right decision. My advice is simple – get the analysis in writing from her financial advisor and then get a second opinion.