Personal Finance

The commuted value of a government pension if bonds approach 0%

  • Last Updated:
  • Nov 26th, 2019 1:02 pm
[OP]
Newbie
Apr 14, 2016
15 posts
11 upvotes

The commuted value of a government pension if bonds approach 0%

So, lets say I'm a government employee leaving for the private sector has the option of a deferred pension at 65 (a few decades away) or taking the commuted value of that pension. My understanding is that the commuted value is based on the current bond market, which are currently pretty damn low, thus making for a large commuted value (although not as large as 3-4 years ago). What would happen to this commuted value in the event of further lowering of Canadian bond rates towards zero, or even below zero as some countries are currently seeing? The pension office people can't tell me, would only tell me to hire the services of a financial advisor or actuary. Even after escalation got no one on the phone that would deal with the question. Surely the commuted value doesn't approach infinity, but what does happen? How's it calculated?

Would a smart move be to remain on a flexible contract in order to leave after the next recession hoping interest rates drop significantly?
18 replies
Newbie
May 4, 2017
32 posts
10 upvotes
Vancouver
So in my situation I have to quit before age 55 to get the commuted value. After age 55, if I leave my employer, the money has to be kep in the pension to take at 60 or 65.

Pure speculation is that if the interest rate put the pension in jeopardy due to being able to take the commuted value, they would change the rules ... eg. no one can take the commuted value - so sorry, too bad.

I also asked about the commuted value with the pension folks, wouldn't tell me unless I committed to quiting/retiring. I looked up some commuted value calculators - highly variable results.
Last edited by wolfie55 on Nov 23rd, 2019 9:42 pm, edited 1 time in total.
Banned
Aug 23, 2019
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0 is the lowest interest rate to base it off of
It’s simple math
Banned
Aug 23, 2019
899 posts
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MrRoboto69 wrote: So, lets say I'm a government employee leaving for the private sector has the option of a deferred pension at 65 (a few decades away) or taking the commuted value of that pension. My understanding is that the commuted value is based on the current bond market, which are currently pretty damn low, thus making for a large commuted value (although not as large as 3-4 years ago). What would happen to this commuted value in the event of further lowering of Canadian bond rates towards zero, or even below zero as some countries are currently seeing? The pension office people can't tell me, would only tell me to hire the services of a financial advisor or actuary. Even after escalation got no one on the phone that would deal with the question. Surely the commuted value doesn't approach infinity, but what does happen? How's it calculated?

Would a smart move be to remain on a flexible contract in order to leave after the next recession hoping interest rates drop significantly?


Your pension is a defined benefit plan. The commuted value is the Present value of all the future payments. The interest rate for this math is the discount rate. However this rate can’t be less than 0%.

If you are retiring at 65 and they need to pay you out until age 90 the stream of payments is 25 years

If your defined benefit promised to pay you $10,000 a year then the maximum cash buyout would be $250,000. They don’t need to pay you out based on negative rates because they are commuting the Actual dollar payment that they owe you. That is they are only commuted to $250,000 because that will net you 10000 a year for 25 years.

This will obviously depend on your Defined plan and other things as well e.g if they factor in pension indexation into the commuted value math etc.

It’s also not as black and white as I paint it above but that’s the overall math logic
Last edited by Doebird on Nov 23rd, 2019 9:59 pm, edited 2 times in total.
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Aug 23, 2019
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wolfie55 wrote: So in my situation I have to quit before age 55 to get the commuted value. After age 55, if I leave my employer, the money has to be kep in the pension to take at 60 or 65.

Pure speculation is that if the interest rate put the pension in jeopardy due to being able to take the commuted value, they would change the rules ... eg. no one can take the commuted value - so sorry, too bad.

I also asked about the commuted value with the pension folks, wouldn't tell me unless I committed to quiting/retiring. I looked up some commuted value calculators - highly variable results.
Because it’s a complex calculation and it costs them money to do it and review it and double review .they also need to lock it in and hold it for you while you make up your mind.

They can’t have employees calling up at all hours of the day to measure the size of their penises based on commuted values.
Newbie
May 4, 2017
32 posts
10 upvotes
Vancouver
Doebird wrote: Because it’s a complex calculation and it costs them money to do it and review it and double review .they also need to lock it in and hold it for you while you make up your mind.

They can’t have employees calling up at all hours of the day to measure the size of their penises based on commuted values.
So true :)
Deal Addict
Oct 6, 2015
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If rates go to 0%, you might want to question whether or not paying such a pension at all realistic or sustainable for the government/taxpayers due to the likely contracting economy.

Yes, there's ways to do the math (they'll probably base it on a rate greater than 0% with some sort of penalty). But one needs to question how realistic such is.
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May 22, 2003
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Doebird wrote:
They can’t have employees calling up at all hours of the day to measure the size of their penises based on commuted values.
Lol, not sure if that was intentional or not
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Feb 1, 2012
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Thunder Bay, ON
The interest rates used for calculating commuted values are specified in Actuarial Standards of Practice of the Canadian Institute of Actuaries, Section 3500 on p.3047.
https://www.cia-ica.ca/docs/default-sou ... 70119e.pdf

Interest rates used are a mixture of 7 year and long term Government of Canada bond yields. For indexed pensions, the interest rate for Real Return Bonds is used, which is higher than nominal bonds. In all cases, 0.9% is added to the interest rate when doing the calculations.

The combination of real return interest rates +0.9% means long-term bond rates would have to be significantly negative for the interest rate used for calculations to be zero or negative.

Why would you turn down indexed, lifetime guaranteed pension income? Most people in the gig economy would love such certainty in their retirement income. The last decade of good investment returns has created a lot of recency effect that is blinding people to how volatile financial markets can be.
Invest your time actively and your money passively.
[OP]
Newbie
Apr 14, 2016
15 posts
11 upvotes
Thanks for the replies everyone.
Doebird wrote: Because it’s a complex calculation and it costs them money to do it and review it and double review .they also need to lock it in and hold it for you while you make up your mind.
I completely understand that it's takes resources to provide a real quote, but they need more information accessible to the plan member. At least being able to give the information already given to me here if I call in. (0% is the lowest rate we will use) Hell, just the fact that 0.9% is added to the bond rates for the purposes of the calculation pretty much answers my question.
Deepwater wrote: Why would you turn down indexed, lifetime guaranteed pension income? Most people in the gig economy would love such certainty in their retirement income. The last decade of good investment returns has created a lot of recency effect that is blinding people to how volatile financial markets can be.
I completely agree with you, which I why I'm so torn over this decision. I'll give you some of the arguments on the CV side.

- The dollar amount of my CV is inflated due to the current low interest rate environment (after income tax on the CV, the sum is equal to about 15 years of pension payments). So I would not break even by taking the pension until I was 80 years old, even if I stuffed the CV money in a mattress.

- I'm still making sure I'm correct on this one, but my pension does not start indexing until I start drawing it and is not retroactive to the period of time from now until age 65. So in reality the above break even date will be even later.

- I am young, I can leave this money invested for nearly 30 years before needing it.

- I am capable of passively investing this money for that time and not screwing around with it. Even a 3% average yearly return for 30 years will deliver a lump sum that is equal to 38 years worth of pension payments. A 5% yearly average gives a lump sum equal to 65 years of pension payments. The starting lump sum in these calculations is what I will receive after paying income tax on the CV.

- If I die early while drawing a pension, spouse gets about half payments, kids get very little and only while they are in school. Whereas taking the CV, and not screwing up the investing of course, the whole amount is available in my estate.

- I have another source of medical coverage in retirement years.

- My understanding is that this CV is the amount required to purchase an annuity similar to my pension, why doesn't everyone purchase an annuity therefore with their investment proceeds for retirement?

- It would be very neat to receive the large cheque lol.

Not trying to be argumentative, please destroy my arguments if you can! Looking for any info, considerations you may have.
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Aug 23, 2019
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MrRoboto69 wrote: Thanks for the replies everyone.



I completely understand that it's takes resources to provide a real quote, but they need more information accessible to the plan member. At least being able to give the information already given to me here if I call in. (0% is the lowest rate we will use) Hell, just the fact that 0.9% is added to the bond rates for the purposes of the calculation pretty much answers my question.



I completely agree with you, which I why I'm so torn over this decision. I'll give you some of the arguments on the CV side.

- The dollar amount of my CV is inflated due to the current low interest rate environment (after income tax on the CV, the sum is equal to about 15 years of pension payments). So I would not break even by taking the pension until I was 80 years old, even if I stuffed the CV money in a mattress.

- I'm still making sure I'm correct on this one, but my pension does not start indexing until I start drawing it and is not retroactive to the period of time from now until age 65. So in reality the above break even date will be even later.

- I am young, I can leave this money invested for nearly 30 years before needing it.

- I am capable of passively investing this money for that time and not screwing around with it. Even a 3% average yearly return for 30 years will deliver a lump sum that is equal to 38 years worth of pension payments. A 5% yearly average gives a lump sum equal to 65 years of pension payments. The starting lump sum in these calculations is what I will receive after paying income tax on the CV.

- If I die early while drawing a pension, spouse gets about half payments, kids get very little and only while they are in school. Whereas taking the CV, and not screwing up the investing of course, the whole amount is available in my estate.

- I have another source of medical coverage in retirement years.

- My understanding is that this CV is the amount required to purchase an annuity similar to my pension, why doesn't everyone purchase an annuity therefore with their investment proceeds for retirement?

- It would be very neat to receive the large cheque lol.

Not trying to be argumentative, please destroy my arguments if you can! Looking for any info, considerations you may have.
30 years left until what, age 65?
so you're say 35 now?

LOL what do you think your commuted value is going to be??

Unless your executive level with the government, your pension plan is what....?? 2% X 5 year average X years of service??? IF you're lucky that it's 2% up to YMPE and 2% over YMPE??????

so you have like 10 years of service??? you'll get whatever you've put in+ your employer... lol you're way over thinking this...….

Unelss you've been with them since 20 years old and been earning decent money, then you might get a decent payout... but if it's been like 10 years or less.. At most you might get $100,000 into a locked in account...… (note: I have no details about your income/pension plan/etc.... but based on your line of questions you're just an average salary worker with the government.. you make, what, $90k right now, with 5-10 years of service??)

yeah you're way way way over thinking this man.
[OP]
Newbie
Apr 14, 2016
15 posts
11 upvotes
Doebird,

Please ask some reasonable questions before being disrespectful. I fully understand what my commuted value will be, I have a quote from my pension representative stating exactly what it would be if I took it today. How do you think I could calculate what the lump sum will be after I pay income tax on it, or the break even points otherwise? It is not an insignificant amount of money. As I'm sure you can appreciate, I am unwilling to share all details of my finances on an open internet forum, but rest assured the ratios I posted regarding sums and break even times are accurate.

I'm sorry I posted some arguments you disagree with, I was hoping for reasonable discussion. In any event, regardless of the size of the CV, you could address the significant decisions anyone in my position should consider regarding investment growth rates and time to break even with the deferred annuity. I'd appreciate it if you would do so with any further replies.
Last edited by MrRoboto69 on Nov 24th, 2019 7:35 pm, edited 1 time in total.
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Jan 14, 2010
644 posts
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Central Ontario
I was (un?)lucky enough to get downsized in 2016 and took the commuted value. As noted, everyone's scenario is different (year of service, years left to retirement, savings, spousal pension, etc.), but @MrRoboto69 you seem to be in a similar situation to mine. Accountant worked out that I'd have to get 2-3% to approximate the estimated lifetime pension (yes, this is due to the indexing not beginning until pension initiation and ending contributions for so many years until planned retirement).

I've done ~10% in last 3.5 years and am completely happy to have had the independence to manage this fairly large lump sum. Even if I'd gotten -3% for last 3 years, I still believe in my ability to hold to my investment strategy with good long term effects; it just so happens that my employment misfortune came at a time when interest rates were low and caught the beginning of a good bull run so I've front-end loaded my returns significantly in case weaker years are ahead.

@Doebird, you are mistaken in your estimations in post #11.
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May 4, 2017
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Vancouver
In my own situation in spite of the pension being very well run as per the results each year, I would elect to take the CV (I'm in BC). The main reason is the way my pension would pay out, from 5 yr guarantee to 10 yr, or 15 yr, each option paying out a little less per month, in case of death the longer the guarantee period, your spouse or estate would get the guarantee years continuing payout but that's it. My way of thinking is I earned it all of it, so I want all it to go to spouse or estate and divided as per my will (and not cutoff after guaranteed years). But that's not how it works at least the way my pension is structured. You get what you get, it's not terrible by any measure.

I'd rather take the CV, have it grow tax free in a LIRA, and have it as an asset for my estate.

But the reality I will probably work past 55 so taking the pension as it is, is also fine by me. I'd could lean fire at 55, but I don't want to at least as I'm projecting a few years into the future.
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Feb 1, 2012
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Sounds like you have given it some thought and learned how to invest.

I'll provide some comments based on my own experience. I have taken the commuted value twice, neither of them were indexed, and both companies had some tenuous financial circumstances. If they were indexed well backed pensions I may have made the opposite decision. In the second one, the idea of taking the commuted value came up with my co-workers several times. I would ask people questions such as had they ever invested that much themselves, how would they invest it, what would they do in another market crash like 2000 or 2008, do they have a good advisor, what is their investing strategy, do they understand the impact of cost on long-term portfolio returns etc. Most of them could only respond with a vacant stare. Sounds like you could easily answer all those questions.

  • Yes, I believe indexing starts when you begin taking the pension. x% per year of employment at your final average salary, less any reduction for taking before normal retirement age, usually 65.
  • Lots of people consider that if they take the commuted and die early the remaining value stays in the estate, whereas the pension drops to a survivor level when the first spouse dies and ends when the second spouse dies. But they don't look at the other side of the equation, that the indexed pension continues to pay, no matter how long they live.
  • Yes the CV and annuity calculations should be similar. But people that take the commuted want to manage it themselves, so unlikely to buy an annuity. Plus the insurance company may have higher costs than the pension manager, and the annuity sales rep definitely takes a cut for their commission. I will consider an annuity for part of my portfolio when I get around age 75-80, depending on my health and investment returns
  • I think the 0.9% that gets added to the interest rate is because pensions invest in balanced portfolios, not just long term bonds. I assume the 0.9% is the risk premium of a conservative balanced portfolio over long-term fixed income.
  • Re break even at age 80. Yes, pensions are based on actuarial calculations using average life expectancy age early to mid 80s. So using the same interest calculations for the commuted, it should break even around life expectancy. Yes if you die before breakeven you lose out, but that's how DB pensions work. Members that die early create mortality credits that enable lifetime payments no longer how long other pensioners live.
  • If you take the commuted you have to ensure you have enough to survive on as long as you live, whereas the pension spreads longevity risk over thousands of members.
  • Maybe I have misinterpreted, but it seems you are focusing on positives of the commuted and negatives of the pension. Consider some what-ifs, especially on the down side. Such as what if you and your spouse both live a very long time? More and more people are living to 90, and some even to 100. What if inflation spikes up high like it did in the 70s? Equities cope with inflation to a point, but very high inflation drives up interest rates, which then may drive stock prices down to restore the equity risk premium. It happened in the 1970s. $1000 invested in the S&P500 at the start of 1973 was only worth $627 at the end of 1974. What if there is a market crash, or even two within a decade like 2000 and 2008? Sequence of return risk could really damage a portfolio in a case like that. Money invested in the S&P500 at the start of 2000 did not get back to its original value and stay there until some time in 2012.
  • One tactic I have heard is if both spouses have DB pensions, one takes the commuted and one takes the pension. That way they have some guaranteed indexed income, plus funds to invest themselves.
  • I have no pension, so CPP and OAS will be my only source of indexed guaranteed lifetime income. My withdrawal rate is about 3.5% of my portfolio, and when CPP & OAS start it will drop to between 2.5% and 3%. Considered a safe withdrawal rate under all but the most pessimistic assumptions. But it still weighs on me that I must manage my own $ no matter how old and mentally or physically challenged I get. A good indexed pension takes away a lot of that stress
  • Yes it's neat to receive a really large cheque. It's also neat to manage a really large portfolio. :)


Here are some links you may find helpful (yup, I read a lot before making my decision):
https://www.theglobeandmail.com/globe-i ... e27633794/
https://www.thebalance.com/how-to-compa ... ty-2388838
https://www.kitces.com/blog/how-to-eval ... imization/
https://retail.manulifeinvestmentmgmt.c ... to-commute
https://ca.rbcwealthmanagement.com/docu ... 777b7c43f4

Good luck with your decision. Seems like you would do well either way.
Invest your time actively and your money passively.

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