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Commuting pension could buy this Ontario woman more flexibility in retirement

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Commuting pension could buy this Ontario woman more flexibility in retirement

If she can make her money grow at three per cent per year compounded for 20 years, it will nearly double to $308,040Author of the article:Andrew AllentuckPublishing date:Jul 31, 2020  •   •  5 minute readArticle contentIn Ontario, a woman we’ll call Lydia, 45, is raising three kids in their early teens. Lydia’s monthly income, $4,500…

Commuting pension could buy this Ontario woman more flexibility in retirement

If she can make her money grow at three per cent per year compounded for 20 years, it will nearly double to $308,040

Author of the article:

Andrew Allentuck

Publishing date:

Jul 31, 2020  •   •  5 minute read

Article content

In Ontario, a woman we’ll call Lydia, 45, is raising three kids in their early teens. Lydia’s monthly income, $4,500 after tax plus child support of $1,465 plus half the non-taxable Canada Child Benefit of $370 per month, totals $6,150 per month. On her own, Lydia’s communications consulting business is a one-person shop, inherently fragile. In retirement, she will have a defined-benefit pension that can pay her $12,840 per year. How she handles the choice of taking the pension is vital to her life in retirement.

Lydia is her own boss in her three-year-old business. Fearful of debt, she owes only $276,330 on her home mortgage and $25,000 on a loan from her ex, repayable without interest when she sells her house. Her retirement income target is her present after-tax income.

E-mail andrew.allentuck@gmail.com for a free Family Finance analysis.

“My goal is to continue to work for myself and to save enough to put my children through university and have a comfortable retirement,” she explains.

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Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Lydia. “She has adequate income now. The problem is to maintain that income in retirement,” Moran says.

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Selling the house

Lydia is concerned that she has more house than she will need when the kids leave home. Her question: Will money extracted in downsizing along with her pension from a former job and her savings produce at least $65,000 per year after tax, her retirement income goal?

Selling her large house and buying a smaller one would adjust her asset mix, Moran explains. The house is 80 per cent of all assets if the RESP is excluded from the calculation. She could pay off the mortgage with its remaining 27 years of amortization. Money saved could be diverted to retirement.

If she can get market value, say $950,000 less five per cent for selling costs, net $902,500, then pay off the $276,329 mortgage, she would have $626,171. Pay back the $25,000 loan and she would have $601,171. If she buys a new house for $500,000, she could add about $100,000 to retirement savings, bringing the total of her RRSP and TFSA savings, currently $203,080, to $303,080.

Allocating fresh funds to savings would be an opportunity to pay less tax. If she moves $17,463 in the TFSA to her RRSP, she could get a tax refund of about 30 per cent, or $5,239. That could be added to savings for a new total of $308,319.

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That capital, enhanced with $10,000 annual contributions for the 20 years to her age 65 would become $833,623 and then growing at 3 per cent a year after inflation, support payouts of $41,300 per year for 30 years until the fund is exhausted.

The children have a substantial RESP of $179,375 funded by a relative. Lydia adds nothing.

To commute or not to commute?

When retired, Lydia can draw on a defined-benefit pension from a former employer. She can wait to take the pension of $1,070 per month beginning at age 65 or she can take an upfront payment known as the commuted value of the pension. In her case that totals $170,540 — it is equivalent to the capital that would be required to pay her the pension for her expected lifetime. The employer’s interest rate assumption for calculation of the commuted value is 1.3 per cent for 10 years and 2.4 per cent thereafter. These rates reflect current government bond interest. If rates rise, the commuted value would be lower. These are low rates of growth set on expected returns of government bonds. But these low rates boost her commuted value. Indeed, rates have never been lower.

The critical difference in taking the commuted value is the potential for growth of capital between today and age 65. That is 20 years. If she can make her money grow at three per cent per year compounded for 20 years, it will nearly double to $308,040 in 2020 dollars. Then spent evenly over the 30 years to her age 95, it would support income of $15,258 per year, adjusted for inflation. As is, her pension, which will pay $12,840 per year, has no inflation adjustment. It will lose purchasing power steadily. Taking the commuted value is preferable, Moran concludes.

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There is a caveat, however. In taking the commuted value, Lydia would accept the management risk that comes with investing in stocks, bonds, ETFs or mutual funds. She may beat index numbers as we have given them or she may lose a little or a lot. However, the amount of the potential outperformance of the commuted value converted to her own capital makes the risk worthwhile, Moran says. Moreover, approximately $120,000 of the commuted value must be transferred to a Locked-in retirement (LIRA) and thus sheltered from immediate taxation. She has $61,000 in unused RRSP space. That can be used to reduce the tax problem on the taxable portion of the transfer.

Retirement finance

In retirement at 65, Lydia will be eligible for annual Canada Pension Plan benefits of $12,700, $7,362 per year from Old Age Security, $40,825 from savings and $15,258 return from investment of her commuted value for a total, pre-tax income of $76,145 per year. She would escape the OAS clawback which begins in 2020 at $79,054. After paying 20 per cent average tax, she would have $5,075 to spend each month.

Her total income would be less than her target $6,500 per month, but her mortgage, RRSP contributions and the cost of raising three children would be history. Her expenses would decrease by $2,670 to $3,480 per month, leaving her with $1,595 additional monthly discretionary income.

Taking commuted value shifts the risk of beating or losing to inflation to Lydia. The choice is hers.

Retirement Stars: 4 **** out of 5

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E-mail andrew.allentuck@gmail.com for a free Family Finance analysis. 

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