Episode 385: A Case Study on Pension Benefits vs. Commuted Values

26:07I'll take a couple of minutes here and maybe just describe some of the inputs that I put into the software, and then some of the results that I saw. Let's start with scenario one was taking the commuted value. And I looked at a couple of different options here. I'll give you some of the numbers that we were talking about that I entered into our software. So taking the commuted value actually involved receiving two amounts of money for this client. The first is the locked in amount that was going to be transferred into a locked in retirement account. This amount was $1.267 million. The locked in amount is an amount that corresponds to the maximum tax-sheltered transfer value that can go into a locked-in retirement savings arrangement.

26:57It's an amount that is received on a tax-deferred basis. There's no upfront tax hit for receiving this amount. The amount is calculated based on the Income Tax Act in Canada, which provides an age-based factor that is multiplied by your annual lifetime retirement benefit. That's what determines the maximum transfer value. This amount is only based on the expected pension benefit. it doesn't take into consideration the value of other benefits, such as the cost of living adjustments, or in some cases, when you receive a defined benefit plan, you also get medical benefits with that. Those additional benefits are excluded from this maximum transfer amount.

27:39Oftentimes, the maximum transfer amount is actually less than the true cost of the benefits that are being provided from the pension. The additional benefits, so things like cost of adjustment or medical benefits, those are paid out on what is known as the excess amount. That's the second amount that my client was eligible to receive. And this amount was just over$740 ,000. This excess amount represents the amount above the maximum transfer value. And it is fully taxable as income in the year that it's received. You can try to reduce the tax owing on this amount by contributing hopefully a good chunk of it into your RSP.

28:24And my prospective client knew this, but unfortunately had already used up his entire RSP limit for the year because he'd worked a full year, had a salary bonus, has some rental income coming in. So because he had already maxed out his RSP for the year, this entire value was going to be subject to tax at his marginal tax rate that year. I should mention, just because that was the case here for this client, it doesn't mean that in every case when you take the commuted value that you can't shelter some of the excess amount from taxes by making a contribution to your RRSP. In some cases, you can recover some of your RRSP limit through what's called a pension adjustment reversal.

29:07For anyone that has a Canadian pension plan, you'll notice that your available RSP room is reduced each year because of what's called a pension adjustment. You can see the amount of the pension adjustment on your T4 every year, and you can also see it on your notice of assessment from CRA. It represents the total value of the retirement benefits that you earned that year through your company pension. And what it does is it reduces your RSP room for the following year. And the purpose of these pension adjustments is to ensure fairness between those who have pension plans and those who don't. It wouldn't be fair if you had a pension and full RSP room.

29:49It effectively reduces your available RSP room in future years. In some cases, when you take the commuted value, you can recover some of your RSP room through a pension adjustment reversal when the total of your past pension adjustments exceeds the commuted value that you're going to receive. So in the case for my client, had all of those past pension adjustments, those decreases to his RSP room exceeded the 1.267 million that he was going to receive as his locked in value, the difference would have been recoverable for him or would have been added back to his RSP limit. Now, unfortunately, his past pension adjustments did not exceed that commuted value.

30:32And so he wasn't able to recover any RRSP room. So it meant that entire excess amount,$740 ,000, was going to be fully taxable all in one year. And most of that was going to be taxed at the top marginal tax rate in Ontario, which is 53.53 % when combined with the federal tax rate. Man, that's so interesting. So there's the annuity consideration. Is it better to have this annuity versus this risky asset invested? That's one piece of this decision, but there's also a tax decision where the present value of taxes that you'd pay over your lifetime are probably going to be quite a bit higher in the case where you take, I guess, it still depends on how long you live.

31:13But either way, you've got this big upfront loss of tax deferral that you otherwise, if you just take the pension benefit, would defer over time, probably paid a little lower tax rate over time and spread it out over your life. complex decision. Very complex decision, but I do think not to bury the lead of the conclusion here, but that upfront tax hit likely played a big role in the results that I was seeing in the software. Scenario one, again, receiving the commuted value, we modeled receiving this large locked in amount into a lira, just over 1.4 million. And then this large taxable amount, the excess amount, 740k all in one year.

31:52So we compared this and investing this in different asset allocations to leaving the pension with the employer, which was the second broad scenario. The monthly pension benefit was a pre-tax amount of$8 ,515 per month. And this benefit did have a cost of living adjustment, which we assumed would be 2 % per year, meaning that the pension benefits were not actually going to keep up with inflation. We were using a 2.5 % inflation rate in the plan. And then we also included the two-thirds survivor benefit in the event that the pensioner passed away. Oftentimes, we tried looking this up. Oftentimes, pension providers will put a cap on their cost of living adjustments.

32:39So they'll say, okay, they will match increases in inflation up to a certain limit. So we tried to be a bit conservative and say, okay, let's assume that inflation is higher than the cost of living adjustments for the pension throughout the life of this plan. So those are the two scenarios we were comparing. The other inputs to this plan, so the spending goal for this family was$10 ,000 a month after tax index to inflation for life. I also added in a$50 ,000 after tax lump sum expense that occurred once every seven years in the plan, just to capture things like car purchases or large home renovations, just to have some degree of variable spending rather than straight line spending throughout the life of the plan.

33:26We also included estimates of both their Canada pension plan and old age security benefits. They also receive$60 ,000 a year in rental income. They both have a combination of other investments in things like RSPs, TFSAs, and non-registered accounts. And they also own a primary residence and a rental property, both of which we assumed would never be sold to help fund their retirement. Going through all that, maybe I'm biased here, but that seems a little bit better than just going off gut feel or rule of thumb. What were the results. I also thought that it made more sense than just going off of gut feel.

34:04In both cases, whether it was leaving the pension with the employer or taking the commuted value, the plan was successful. They were able to achieve the spending goals that we entered into the plan, which was great. The key question that I then wanted to analyze was which one made them better. And in particular, in a shortened life expectancy scenario, which was the big concern here, was taking the commuted value the better choice than leaving the pension with the employer. And so I ran three different scenarios and I'll share the results of each of them. Each of these scenarios, what we did was we modeled the client living until the normal age that we would usually do, which is age 95.

34:46But I also then modeled what happens if he passed away 10 years into retirement. Take my word for it that the plan was successful either way, all the way out to age 95, really what we wanted to look at were what were the results if he passed away early, just 10 years into retirement. Scenario one was take the commuted value and invest in a 60-40 allocation. We found that the retirement score in the plan was 113%. Retirement score in Conquest in the financial planning software that we're using represents the clients, the way the software defines it is they call it the retirement abilities. So basically their ability to spend money in retirement as a ratio against the expenses that we've loaded into the plan.

35:33So a 113 % score would represent an overfunded plan. Essentially, they had a higher ability to spend beyond the spending goals that we'd entered into the plan. We also, in assessing whether a plan is successful, look at the legacy value. So is there money left over at the end of this plan. And we found that the legacy value was about 5.5 million in present value dollars. When we build these plans, all of the initial calculations are done on a straight line basis, assuming guaranteed returns from the investment portfolio, which we know is a dangerous assumption to make. So we also run 1000 Monte Carlo simulations to include variable investment returns throughout the life of the plan.

36:17And the results of the Monte Carlo simulations come in a volatility score where we see of the thousand simulations, in how many of them were we able to achieve the funding goals and the spending goals in the plan versus how many were we not able to achieve the spending goals. In the case of taking the commuted value, investing in a 60-40 allocation, the volatility score was 84%, which is pretty closely aligned to our target. We're generally looking for anywhere from 80 to 90 % we would consider to be a successful plan. And so taking the commuted value and investing in a 60-40 allocation, we judged to be a successful plan.

36:59The second thing that I looked at, and hopefully the Rational Reminder community will be happy that I modeled this. What would it look like if they took the commuted value and invested 100 % in equities throughout the life of their retirement? And we found that this did make some improvements to the plan. So the retirement score went up to 139%, which makes sense. If we're getting a guaranteed higher expected return, we would expect the plan to look better. The legacy value also increased to 6.4 million in present value dollars. Interestingly, though, the volatility score in the Monte Carlo simulations was about the same as investing 6040.

37:39The volatility score with the 100 % equity allocation was 83%, indicating that when market volatility was considered, this plan was failing about the same amount of the time as investing in 6040. That is interesting. So in that case, you call it the same, the same roughly volatility score, the same success rate or whatever. In the 100 % equity case, you've got a higher expected legacy. So you still have about the same chance of having a bad retirement spending outcome, but on average, you expect to have more wealth at death. Exactly. We've seen this lots of times in client scenarios where the Monte Carlo result is very similar when you have higher equity, but the tails are much wider.

38:25So higher potential on the upside, but also you could be worse off on the downside. Exactly. Those were the results for taking the commuted value, investing the money themselves. And I compared this to then leaving the pension with the employer. What I found was that the retirement score was very similar to that of the 60-40 scenario. The retirement score when leaving the pension with the employer was 115%. The legacy value was about the same as the 60-40 scenario as well, 5.5 million in present value dollars. But what was very interesting was that the volatility score was 96%. So a significant improvement, in my opinion, above the results of investing the money themselves.

39:14In trying to assess why we were getting such a better result here, I see a couple of likely explanations. I think pretty obviously in the simulations that feature poor market returns, the client is still receiving his defined pension benefit payments. The pension is substantially raising the floor of guaranteed income in retirement. And because the pension payments have that cost of living adjustment, the pension is acting as a hedge against both volatility risk and inflation risk, which I thought was pretty attractive. And then the other thing was the thing that you mentioned earlier, Ben, which was leaving the pension with the employer allows the client to avoid taking such a large tax hit on that excess amount upfront.

39:58And effectively, they're able to smooth out the tax liability on those benefits over more tax years. With this in mind, I presented this to the client and felt that there was a pretty good case for leaving the pension with the employer rather than taking the commuted value. Even in the case, again, remember, all of these results are based on him passing away 10 years into retirement and his spouse receiving a pretty significantly reduced pension. Even in that scenario, it seemed to me like leaving the pension with the employer was potentially the better choice. And the client's reaction to this was they were very grateful to see this analysis.

40:37They'd assumed that the shorter life expectancy automatically meant that taking the commuted value would be the better decision. So having the data to actually quantify the different outcomes of each decision was enlightening for them. And ultimately they agreed with me and decided to leave the pension with the employer. That all makes sense to me. Did they arrive at the conclusion that taking the commuted value made sense on their own or did they talk to any other firms before talking to PWL? I think that that was their initial conclusion on their own, but they also did interview several other firms in addition to PWL.

41:16My impression in talking with them afterwards is that we were the only ones that did this kind of analysis for them. I think everybody else just kind of went along with, yeah, okay, we'll invest these funds for you. And here are some ideas related to that. They were pretty grateful to see this analysis and commented afterwards that nobody else had shown this to them. Super interesting. I find this fascinating. At face value, it seems like a relatively simple decision. Should I take this community value to find benefit pension? I've got a health concern. Let's take the cash to avoid that risk. When you actually dive into it, it's a much more complex decision.

41:55And the average person can't do this analysis without proper tools and knowledge of thinking about all these factors. You think about inflation, you're thinking about tax impact, the volatility of the equity if you invest that way. There's a whole bunch of different factors here that change the complexity of this decision, even though it seems like a relatively easy choice. And they had quite frankly already made that choice. You basically had to show them this isn't the right choice. And even though it's the right choice, it's not even the choice that's in the best interest of PWL. This is clearly in the best interest of the clients.

42:32If you had taken the commuted value, you would have had 1.5 million or something to invest after tax in a PWL portfolio where we earned fees on it, which is crazy. We basically said, no, this isn't the right choice. This isn't going to benefit us, but we want to give you the right advice that's good for your future. It doesn't sound like Phil said this isn't the right choice. We talked about this in a recent episode about base rates. So much of a role is providing base rates. In this case, the client came with a preconception about what they should do. Phil just laid out, here are three different scenarios.

43:08Here are the expected outcomes of those scenarios. What do you think makes sense? And then they are able to make a decision with better information. So it's not so much do this. It's here are the base rates. Here's the information required to make a decision. What do you think? And we can, of course, influence the direction people go in. But I think providing that base rate information to help people make their own good decisions is a huge part of what we do for clients. That's a good point. We often go through, here's the scenarios that we reviewed, one, two, and three. We recommend scenario X for this reason, and you can make your decision.

43:44Any questions, let us know. But here's the analysis we went through and what led us to our conclusion. in? Everyone, when it comes to financial decision-making, people are different. People have different values, different things that they might prioritize. Oftentimes, trying to present the data objectively in this way is helpful for that decision-making. But I find when I'm working with clients, a lot of the time I'll say, well, based on what I know about you and your personal values and what's important to you, maybe you're giving weighting to a particular aspect of the decision based on its importance to you for whatever reason.

44:22So maybe that ends up being the optimal decision as opposed to another choice that you might make. It really is this combination of weighing what does the data say? What are your values? What's important to you? How does it make you feel? This type of analysis, I think, should be done on an individual basis for everybody rather than just relying on rules of thumb or just saying what's important to me. I think these things in combination lead to hopefully good decision making that aligns with your own personal values. After this process, you kind of led them to make the decision to keep the pension.

44:57What other decisions followed from that? There was another big decision after landing on the decision to leave the pension with the employer. They are then given a sheet where there's all these different pension options that they have to choose from. The main crux of the decision was, do I take a higher pension benefit with a lower survivor benefit? So you could take a higher pension amount with a two-thirds survivor benefit. Or there was another option that involved receiving a lower pension benefit, but with a 100 % survivor benefit for his surviving spouse if the client were to pass away. After doing all of that initial analysis, we were then faced with the second question, which was fun to dive into as well.

45:41The way that we tried to frame this question was we said, okay, how long does the client need to live in order for the first option? So the higher pension benefit with the lower survivor rate, how long does he need to live for that decision to come out ahead compared to the one with the higher survivor benefit? Intuitively, we understand if he were to pass away a year into retirement, the option with the higher survivor benefit was going to be the better choice. If he lived for a long period of time, then option number one, where he's receiving the higher pension benefit for himself would end up being the better choice.

46:21And so we needed to figure out where the break-even point was. To figure this out, we built a chart that totaled the amount of combined pension benefits received for the couple based on death at every possible age between ages 65 and 95 for the client. In looking at that, we determined that the break even occurred at age 81, meaning that the client needed to live for about 16 more years for option number one to come out ahead compared to option number two with the higher survivor benefit. And what's interesting is that when we presented this analysis, he actually felt pretty good about the break-even analysis and decided to take the first option with the higher pension benefit for himself.

47:07So we went from taking the commuted value due to potential life expectancy considerations to figuring out kind of a compromised solution to a degree where we're going to leave the pension benefit with the employer, but take the higher pension amount. I just thought it was really interesting that that was the choice he ended up landing on. Super interesting. Such a crazy contrast from the beginning where I want the commuted value because I'm worried about health risks. Oh, it's actually not that bad. I'm going to take a bet on my life expectancy to live beyond age 81 is essentially what he said.

47:43You see the financial planning outcomes. It's so hard for people to think about long-term financial stuff because compounding is hard to think about. People suffer from the exponential growth bias, all that kind of stuff. So when you ask someone a question like this, it's really, really hard to have a mental model of what makes sense. So when you use a software that accounts for expected returns, taxes, inflation, all that kind of stuff, and you see, oh, this is how that changes the expected outcome. And we see this with clients all the time. That tends to give people a ton of peace of mind. Because it's something that you just can't think through easily in your head.

48:20It makes sense that once you see, okay, that's the expected outcome, even if I pass away early, that's not nearly as bad as I thought. Let's take this option. Very, very cool case though, Phil. I really appreciate the opportunity to come on and share this and just give people a look kind of behind the scenes in terms of what we're doing on a day-to-day basis. My favorite things about this story though, are I love the fact that a podcast listener himself, a DIYer with a high level of financial literacy, referred someone in his circle that he knew would need professional help. I love that the decision was made using objective data rather than trying to guess what the optimal decision was going to be based on rules of thumb.

49:02I also wanted to just highlight what you guys said earlier, which is the fact that for me, working here at PWL, the fact that the firm is a place where we truly put the best interests of clients first is so important to me. I love that this is a story about turning down a large sum of money that we could have managed and charged fees on. And nobody that works here is disappointed that I did that. Instead, this is a story that we're celebrating and that we want to showcase. I really do believe that situations like this can lead to a win-win. Ultimately, these folks are still coming on board as clients.

49:36They're going to have us manage the rest of their investment assets, the trust that we built by doing this analysis upfront, by giving them objective advice that was in their best interest, I think is going to lead to a great long-term relationship. And so I'm super excited to be working with them. Super excited that I had the opportunity to do this planning upfront. This was a lot of fun. That's awesome. I think doing good planning that's in the best interest of clients always trumps closing a sale quickly. There's no way around that. It's part of our culture, and that's just something that we have always done.

50:11That's something that Cameron always did. It's something that I find super, super important. As we've grown, every person that we've hired has that same belief system and same approach. There's a cultural aspect, and then there's the incentive aspect. Even if we had that, it will be hard to have that culture. But even if we're hiring people like that and then paying them 2 % of all new investment assets, it becomes a lot harder to make those good values-based decisions when you're staring down a potentially huge bonus, but that's not how we compensate people. So I think we have just this incredible culture, the right incentive structure that really, really puts clients first.

50:47And we have people who want that. If we had people who wanted to live in a sales environment, none of it worked. So those two things, I think the incentive structure and the culture, they work together to create this client first environment that we have that our people want to be in. Absolutely.

51:06the marketing team along with myself would come up with a new landing page on our pwl website to kind of highlight mna it's going to be a spot where we over time we'll add some mna related content add some resources for anybody that's curious to learn what it's like to be part of pwl so if you're an advisor out there curious there's also a web form on there where you can reach out to have a confidential, no obligation conversation just to compare notes and see what we're doing. We love learning about practices and what advisors are doing out there. Just a new spot on our website and we're going to link the page in the show notes if anyone wants to check that out.

51:48People should check it out. People got to hear from Trevor and Brett earlier about their experience making that decision and then being part of the firm now for a few weeks. they've heard from Connor and Taylor a while ago, and hopefully they'll continue hearing from more people who have decided to join our firm. But it's really cool, man. When we talked to Trevor and Brett, I don't know if we said this when we were recording or not, I can't remember, but hearing the external perspective on PWL's culture, I guess not external anymore, but from somebody who's come from the outside and is looking at PWL, as opposed to us who have been in it for so long, hearing them explain what they see and what it feels like to be a part of, man, it's cool.

52:22It's a really fun part of my career so far has been this pivot toward like, hey, we can welcome people who have built their own successful businesses into what we've built. It's a very cool thing to do. It's super fun. And in our chat with Trevor and Brett after, we dove a little bit deeper and said, when you made that decision to turn us down the first time, what went into that? And it wasn't really anything about PWLs. This is getting real. We need to have a self-reflection to understand what's important to us, what we value. And the thing that I found super interesting was that Trevor and Brad are at different stages in their career.

53:00And they admitted that they both value different things, but they both aligned with this model despite being at their different stages, which was a pretty cool insight that they provided after. Totally. And it is a big decision. We went through the same thing. When people started approaching us, we shut people down for years. and then when it got more serious in more recent history, we still shut people down. Took a long time for us to wrap our heads around the opportunity that it could create. Neat stuff. Hopefully we can keep having those conversations and have new awesome people join our firm.

53:33For sure. All right. Anything else? That's it. Very cool. Thanks everyone for listening.

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