I recently worked with a client who was weighing the options for his defined benefit pension. He had retired early and was given three choices for his plan:
A) take the monthly payment from his pension company,
B) commute the lump sum value, and
C) buy an annuity from an insurance company.
After reviewing his financial situation, we determined he didn’t need a large(r) estate benefit and had plenty of personal savings for flexibility in his retirement. So we ruled out option B (the lump sum). I’m generally anti-annuity in low interest rate environments which lead me to believe that option A would be our eventual winner.
When we quoted the annuity, I was truly surprised that this route would not only match the pension payment BUT also leave him with a nearly six figure surplus! The annuity option was suddenly a “no brainer” for mimicking his pension while also unlocking tens of thousands of dollars in additional retirement funds.
Why did this work so well for him? Who else should consider the “road least taken” and buy an annuity?
Why does it work?
When it comes to an annuity vs. pension payments, they operate very similarly. Both provide a guaranteed income for life, flexible estate benefits, and equivalent taxation.
When you buy an annuity with your pension proceeds, the insurance company is required by CRA to match every detail of your pension. Both income streams MUST be identical and, if the insurer can underwrite at a lower cost than the pension company, you may be eligible to pocket the surplus!
What causes the “surplus”?
The most common causes of a surplus will be: interest rates and estate benefits.
If you get lucky, interest rates may fluctuate in your favour from the time your pension offer is made to the time the insurance company provides a quote. Alternatively, the insurance company may be offering a more advantageous interest rate in their calculations than the pension provider.
When it comes to estate benefits, some pension providers mandate specific estate clauses that aren’t relevant to your situation. For my client, his pension company mandated that 2/3 of your pension be paid to a surviving spouse (if you have one) and charged all members equally. He is single, so this “feature” was not only irrelevant but an expense that isn’t applied to a private annuity.
Who is this for?
If you are a member of a defined benefit pension plan and are considering the pension payment, you should always get a quote on the annuity. It can’t hurt to know all of your options and most Financial Advisors won’t charge a fee to run the quotes.
Even if you’re not eligible for a surplus, having your retirement guaranteed by an insurance company is an attractive feature unto itself. Insurance carriers are mandated to hold large cash reserves and have their contracts backed by Assuris. Defined benefit plans, however, can become underfunded if the employer faces financial hardship (e.g. Sears Canada).
If you’re nearing retirement and unsure about how to handle your defined benefit pension, start planning now. Pension decisions are some of the biggest financial decisions of a person’s life, so getting it right is crucial! Weigh all of your options and you never know what kind of rewards you may find.
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