Advising on Pension Plan Options and Transfers

by Peter F. Baigent CFP, CLU, CHFC, RFP.

An article about analyzing the pros & cons of a clients pension benefits and options. By: Peter F. Baigent, CFP, CLU, CHFC, RFP.

In a large number of planning situations the client or clients will have assets in a pension plan from a previous employer. Usually a lot more information is needed in order for you to render an opinion. But it is also a very worthwhile pursuit. With diligent digging there are very often opportunities available to the client that they are not aware of.

Unfortunately it is not always an easy decision as there could be many factors to be considered as well as soft facts in order to make a decision. Perhaps I should have said fortunately. Because if our advice came down to making only a simple mathematical calculation we would be redundant and our work would be done by an ATM.

In many cases there are a number of advantages to moving the money away from the former employer but it is still necessary to compare the future benefit, to the other opportunities available to the client.

Pension Assets With Former Employers It is not uncommon to find that the commuted value of a clients pension assets are in excess of a million dollars. A significant number of clients will have some entitlement to a future pension from one or more of their former employers. Usually they will know little about the benefits or options available to them, other than the pension starting date. Here is where a lot of digging pays off.

I usually start with a request that the client bring to the next meeting any documentation regarding the former pension plan. At that time, if necessary I will get an authorization signed to allow the former employer to provide information to us about the benefits and options available to the client. The client tends to focus on the amount of their contributions only. They often overlook the fact that once they are vested (often 2 years) they are entitled to their contributions, plus the employers contributions, plus interest. For a long-term employee with a generous pension plan this can be a great deal of money. In fact, it will often be their single largest asset. It therefore becomes critical to fully explore all of the options.

I remember a case a number of years ago where the client had a pension plan from his former employer that would start in five years when he reached age 65. It did not appear to be transferable and it did not contain much information about early retirement benefits. It did give a fixed pension amount at age 65. So I sent a letter with our authorization to the former employer asking a few pertinent questions. In particular I wanted to know what the pension would be if he started it at his now age 60. The reply came back quickly stating that there would be no reduction. What a windfall, 5 more years of full payments from the pension plan with no reduction, but no improvement in pension if he waited five more years. The institution he had been with had good reasons to make the pension plan that way but they did not communicate it well to their employees in the pension documents.

Not every case is so simple, as they often require that you do some financial calculations and some thorough assessment of the clients situation with how it impacts on the decision to wait for the pension, or transfer the assets out to an IRA or other tax sheltered plan. on a trustee-to-trustee transfer. If the plan is not indexed the calculation is relatively simple. With the guaranteed pension at a future retirement date as a known figure and the clients vested pension assets, it is a simple calculation on the computer, or a financial calculator. Using a conservative rate of return assumption you calculate the future value of the pension assets at retirement age. Then calculate the amount of payment that would produce for the clients lifetime. As we dont know what the life annuity rates are going to be then, it is best to use age 90 as the client longevity. So, if retirement were available at age 65 you would calculate a 25-year annuity (90-65) at the same rate of return, with zero as the future value. If the payment amount produced in this second calculation is greater than the employers guaranteed pension at retirement, then it is to the clients advantage to transfer the assets out of the pension plan to an IRA for you to arrange the management of these assets. This of course assumes that you have used a reasonable rate of return assumption. In these situations, I always like to use three rate assumptions with the middle one being the anticipated return and the others being two percent below and two percent above the anticipated rate so that the client is well aware that we are illustrating a range of possibilities. This can be presented as three different illustrations, or all on one spreadsheet.

Will the company likely make "Ad hoc" increases to the pension plan for its retired employees? There can be no guarantee of this, but the client can get a good idea of what has happened in the past as an indication of the employers attitude to taking care of its former employees. If the history of Ad hoc increases has been very good it may be fair to compare the pension to a very conservative amount of pension indexing when making the calculations. When my father retired from the financial institution he had been with for many years he took quite a cut for retiring early. His pension was not indexed, but today some 25 years later the Ad hoc increases now give him a pension greater than one hundred percent of his salary at the time he retired. While this sounds great it comes nowhere near matching the rate of inflation in the Consumer Price Index (CPI) of the last 25 years. But the pension increased none the less and is a point to be considered.

For an indexed pension plan the comparison is best done on a spreadsheet. The same future value calculation is required to project the pension assets forward to the prescribed retirement date. From there, the same annuity assumptions need to be used, but a factor for inflation needs to be calculated. Do not assume that the indexing is equal to the CPI index. In many cases it is a percentage of the CPI, or indexing up to, or above a benchmark such as the Average Industrial Wage, or years of service after indexing had been added to the pension plan. If some indexing is provided for former employees who accept the deferred pension is the average salary indexed until retirement date, or just the starting pension? For someone a number of years away from the start of a pension this can be a big item. Either way, you need to be sure of the facts before making any forecasts.

It pays to spend some time studying any Labor legislation applying to pensions in your state or federally as well as the plan documents. Some plans provide for funds after the date of vesting to be locked in, but funds accumulated prior to that date to be unlocked as well as any voluntary contributions. Clients remember the old rules that usually required ten years of service to be vested. Now many jurisdictions mandate vesting after two years, which significantly increases the commuted value of the pension to any employee who had thought they were not fully vested.

The courses of studies for financial planners provide very little instruction on pension plans and almost none on termination benefits in their curriculum. Time spent studying the applicable legislation and the pension plan booklet is usually very beneficial. In addition to discovering ways to help the client, it makes you very referable to the clients former co-workers whom may also be looking for transfer strategies to access their pension plan assets.

Non-Financial Considerations With governments and other employers cutting costs and downsizing, their pension plan obligations appear to have been put on a back burner. As a result a large number of pension plans have a sizeable un-funded liability situation. For clients that are aware of this problem it makes them very prone to deciding to transfer their pension assets out to a financial institution of their own choosing. "A bird in the hand is worth two in the bush." Even now we see employers cutting back on benefits and perks for its retired members such as medical or dental benefits and the like. Although these may well not apply to members who have left the firm prior to retirement it is an indication of coming changes. Many pension plans calculate the departing members value at a reduced rate of interest, not at the rate of earnings of the pension plan. Depending on the past performance of the pension plan this could be a blessing or a curse. If the funds are left with the former employer what assurance is there that the employer will survive? Although the pension assets are secured from attachment by creditors, if it is in an un-funded position who takes the cut? The current employees, or the retired ones? The plan may become even further behind in the future.

Transferring out assets to an IRA by trustee-to-trustee with another institution can offer considerable advantages for tax planning, balancing income and confidentiality, that are not available if staying in the pension plan. This arises when the pension is to start or the funds are eligible (often age 55) to move to the clients IRA. These plans may have a provision for a minimum and a maximum annual withdrawal and that is what produces the planning opportunity. If the client is not in need of the funds, they can be transferred within the minimum and maximum limits to another IRA It should be remembered that pension funds can sometimes be transferred from the pension plan to an IRA if advantageous to do so. This can provide further tax deferral opportunities by drawing the maximum allowed and transferring it to another tax sheltered vehicle. Some plans or jurisdictions have hardship legislation allowing the access to pension fund assets or other tax sheltered plans for financial difficulty, or shortened life expectancy. This opportunity for temporary income, or emergency withdrawals may not be available to the client if the funds were still in the pension plan.

Past Service Before you start a transfer of pension assets it is best to check if the client has any eligibility for past service credits. Many employees are eligible to purchase some past service credits, which they may not have explored. In most cases there was, when they joined the firm a one-year or more waiting period to join the pension plan. In most cases I have applied on, the employer was willing to match the employees contribution for this past service entitlement. The same applies to past service from periods of sick leave, service with related employers, etc. If a client has gone or is moving to a related employer the possibility of transferring into the new plan should be investigated. The decision here will depend on the benefits of the new employers pension plan compared to the old pension.

You will find that this a potential gold mine for the client. And something most other advisors had not addressed. The transfer of moneys from an IRA or similar tax shelter into the pension plan is a painless way to buy this past service. This does not restrict the ability to transfer the pension funds to a IRA afterwards if it is in the clients best interest

Pension Assets at Retirement Time Unfortunately the pension guaranteed at retirement by most pension plans is only a single life annuity. It will usually have a five-year guarantee. For a joint life annuity, which is what is usually required, the client must suffer a sizeable reduction in the estimated pension. The younger the spouse, or the longer the minimum guarantee period, the lower the retirement pension. This is where taking a look at pension maximization strategies may be a better alternative. For those not familiar with that term, it is where the client takes a single life only annuity at retirement and uses the difference in pension payout to fund a life insurance policy, which at the clients death will provide a pension to the surviving spouse.

Again a few simple calculations will determine if the commuted value transferred to an IRA and invested prudently will provide more income than the pension plan. Consideration will need to be given to any benefits like medical premiums up to age 65 which may be lost if the assets are transferred out.

Clients will need your guidance at this time. If they have any voluntary contributions, I usually use them to buy past service credits, or transfer these out, unless there is some advantage to leaving the voluntary contributions in the plan, but I have not found many in the past.

If the plan is not indexed I find that they can usually do better on their own. Then it is usually best to transfer out the assets if possible. If indexed it will depend on the extent of indexing and other factors mentioned earlier.

Whether the client is paying you a fee for your opinion, or you are providing the service in return for the management of their investment assets, the conclusion will be the same if you did the calculations properly. Analyzing pension plans and understanding the opportunities is a huge topic for which some study time is well spent.

Copyright - www.money-software.com

Peter F. Baigent CFP, CLU, CHFC, RFP. is a Past President of the Canadian Association of Financial Planners for British Columbia, a former Director of the Canadian Association of Financial Planners. He has spoken across Canada on financial planning matters and has taught courses for the Chartered Financial Consultants & Certified Financial Planners degrees. He is the founder of Money Minders Software which produces financial planning software.

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