B.C. couple considers commuting their pensions, but managing money comes with big risks
Rather than commute pensions, they could close the gap by spending some of their $256,000 in RRSPs
Gus and Jane's goal is pension income of $120,000 a year before tax.
In British Columbia, a couple we’ll call Gus, 54, and Jane, 48, are looking at retirement options. Both are civil servants and therefore have defined-benefit pension plans. Their gross income is $203,592, equally divided, but planning for the years after work is complicated by their differences in ages, length of tenure with their employers, and relatively low levels of savings.
They have a recreational property in the U.S. with a C$80,000 estimated value as well. They do not rent it and want to keep it, so sale is not part of this analysis. They make no current savings in RRSPs and at this stage of their lives, dramatic increases in their private investments would require them to take substantial risk. The couple is relying on their defined-benefit indexed pensions, but they worry that the pensions may not cover their retirement needs.
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Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Gus and Jane.
To raise cash, they consider commuting Jane’s pension, that is, converting the income flow to capital. Their goal is pension income of $120,000 a year before tax. As we’ll see, they can get that without taking on the risk of converting DB pensions to their own management via commutation.
The pros and cons of commutationDefined benefit pensions are contracts to pay defined sums in future. The money behind the payments belongs to a government unit. It is possible to commute the DB pension to the amount of capital required to generate expected defined pension income flows for an estimated numbers of years. The math is complex: interest rate changes require actuarial work and with some money going into registered plans and some not, there are tax considerations, too. Mortality also enters into the calculation: A DB pension pays for life, which requires a sequence of payments that can be difficult to duplicate via private investments. If they get cash to manage, they might get more out of their pension capital than their DB pensions will pay, but they carry all risk of gain or loss.
Best leave well enough alone, Moran advises. The plans are, after all, professionally managed, and will never run out of money. The downside of the plans is that if they do build up RRSPs before retirement, the payouts will be on top of pension income and perhaps in higher tax brackets. What they might save now with RRSP contributions could be substantially taken back by future taxes.
Investment incomeThe couple should instead focus on debt. They have only one, which is the $130,000 they owe on their mortgage. They can take $30,000 from $35,000 of existing cash and put that down on the mortgage, shortening payments by 20 months or less if rates rise when the loans are renewed and cutting total interest they will pay. If they maintain $1,500 monthly payments, they can have it paid off in about six years, give or take when their mortgage loan is up for renewal in 2025. If they add $74,000 from TFSAs, reducing the balance to $26,000, they could be mortgage free in 18 months. They would be sacrificing tax-free investments to pay off a low interest loan, which is not ideal, but it would get them to zero debt faster.
With the mortgage relegated to history, the $1,500 per month they have been paying would be theirs to keep. Eliminate $200 for life insurance they might not need, add $500 for car replacement, and boost present travel spending of $1,000 per month to $2,500 and their present monthly spending would decline slightly to about $7,000 per month. That’s $84,000 per year after tax or about $100,000 before tax if incomes are split.
Gus can retire next year at age 55 with an indexed pension of $64,940 including a $21,160 bridge to 65. Jane will have a $58,500 pension including a $10,500 bridge to 65, but can’t start collecting it until age 55. Neither would be old enough for Old Age Security or Canada Pension Plan benefits. Commutation to achieve the combined pension flows of $123,440 implies a capital value of about $4.1 million generating 3 per cent per year before tax.
Assuming that they could get this sum, pay tax due, and put the balance in locked-in RSPs, they might each be able to obtain $48,000 to $49,000 from capital after tax. But growing longevity makes it ever more doubtful that the guaranteed-for-life income stream of a DB pension can be replaced, Moran cautions.
Rather than commute pensions, they could close the gap by spending some of their $256,000 in RRSPs for the six years until Jane can draw her pension.
Retirement incomeLooking ahead, Jane has to wait to 55 to start her pension. We’ll assume that a draw of $50,000 per year for six years empties their RRSPs including six years of growth.
When Gus turns 65, his bridge will end and CPP and OAS will start flowing. For the six years to the time when Jane is 65, their income would consist of $91,780 combined base pensions and Jane’s $10,500 bridge, his $12,756 estimated Canada Pension Plan benefit and his $7,518 OAS benefit for total income of $122,554.
When both are 65, they will have $91,780 base pensions, no bridges, two CPP benefits of an estimated $12,756 each – total $25,512, and two OAS benefits of $7,518 each for total, pre-tax income of $132,328. That’s over their $120,000 pre-tax goal. If this income is split and allowing for age and pension credits, they would pay tax at an 18 per cent average rate and have $108,500 to spend after tax. That’s $9,040 per month, far ahead of present spending of $7,110 per month.
With $1,500 monthly mortgage payments eliminated, they would have additional income for travel, a new car fund, or donation to good causes. Their retirement is financially sound, yet their lack of substantial personal assets are a limitation.
Retirement stars: 4 **** out of 5
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