The lurking danger of locked-in pension funds.
Significant market corrections of 2000 and 2001 may be creating cracks in our pension nest eggs. Employees with defined contribution pension plans have had reasonable market performance during the last 10 years, which may have given many individuals a false sense of confidence. But what happens when these funds are converted to income options? And what is the impact of variable rate of return?
The late 1980s and early 1990s were a time of significant pension reform across this country. Reforms included: earlier vesting provisions; portability of the pension funds; and the creation of defined contribution pension plans (DC) all hoping to improve retirement prospects for workers who, in all likelihood, will not enjoy a cradle to grave relationship with their employers.
These reforms were very meaningful, especially during a time of significant layoffs and changing labour markets in the Canadian economy. Prior to these reforms, employees were not vested in a company pension plan until 45 years of age with at least 10 years service. They simply lost funds accumulated from employer’s contributions toward their pensions.
The reforms recognized the movement of employees and the changing nature of the labour market. Provisions in the pension reform allowed terminating and even retiring employees to elect to change their participation from the traditional defined benefit pension plan (DB) to the DC plan or to commute the value of their pensions and transfer them to a locked-in retirement vehicle.
This movement from DB to DC and locked-in vehicles was welcomed by employees and employers alike but for different reasons. Employees welcomed the change for the ability to control their investments and employers for the significant reduction in cost and management.
Employees embarking on a plan transfer have generally been provided with financial planning assistance by the employer. The financial industry has responded in most cases with conservative estimation of what the income generation can be based on average rates of return so that employees can make reasonable estimations and decisions. Excellent guidance is generally provided by the sponsoring financial organization to employees with respect to investing, risk assessment and understanding the importance of diversification during the wealth accumulation period.
However, what has been lacking in this education process is how and when the income for retirement is determined. There is a significant misunderstanding by employees and employers as to how this is determined. In many cases, it is assumed that the income generated from the lock-in plans is similar or the same as Registered Retirement Savings Plans. This couldn’t be further from reality.
A majority of individuals are totally unaware of the income options at retirement from locked-in funds. More significantly, individuals over the age of 50 are increasingly commuting the value of their defined benefits pensions or electing to convert to a defined contribution plan in the expectation that they can “do better” with respect to the income that is produced from a defined benefit pension. Many have made these decisions with the assistance of a financial advisor.
Even with the best of intentions and producing projections at conservative rates of return, many financial advisor do not recognize the impact of variable rate of return on the income generation in future years.
Pension reform places significant rules that determine income flows to the annuitant. At the time of these reforms, legislators had seen more than two decades of interest rates exceeding 10 per cent per annum. Legislators did not anticipate low interest rates and that individuals would be induced to move to equity markets to improve the rate of return of the portfolio. What was also not anticipated is the mix of inflation and variable rate of return on the production of income.
For individuals who are not retiring and do not have to draw down their locked-in funds, market fluctuations are generally a “wait it out” activity. But what happens when individuals require the income to sustain them and don’t have the luxury of waiting out market corrections?
Let’s look at the options:
To generate an income from locked-in funds there are three options available, depending upon in which province you reside.
1) Annuity: which provides a guaranteed income for life at a fixed rate of return.
2) Life Income Funds (LIF): which provides annual income based on a minimum as well as a maximum formula. The minimum rate is usually calculated as the fraction 14(90 minus age of annuitant). For example if the annuitant retires at age 55 the calculated rate would be 14(90 - 55) which equals 2.85 per cent.
The maximum income each year is determined using: 1) the interest rate equal to six per cent for the entire term; or 2) the interest rate on long-term Government of Canada Bonds for the first 15 years and a maximum of six per cent thereafter. If the annuitant lives to age 80, the balance in the fund must be converted to an annuity.
3) Locked-in Retirement Income Fund (LRIF): which provides income based on a minimum as well as a maximum formula. The minimum rate is usually calculated as 14(90 minus age of annuitant). The maximum in the first two years is six per cent and then the previous year’s rate of return, established the maximum income flow.
This option contains the most danger for employees not prepared for the inherent risk involved in using a variable annual rate of return. (Available in Alberta and Saskatchewan, but being considered in other provinces.)
Most information made available to employees uses a conservative annual rate of return of six per cent.
However, the real concern is how in reality this income flows. Anyone who has been investing recognizes that an average rate of return measures the sum of the returns divided by the number of years that are being measured. In fact, the real rate of return that most individuals receive is more of a “Monte Carlo” rate, which means that actual rate of return varies from year to year. One year the rate of return may be a negative the next year 10 per cent, but on average may be six or eight per cent over the life of the plan.
This is only one example, but the ramifications hold through regardless of the random nature and the average rate of return used. There are strategies that can be employed with respect to managing these portfolios, but many of these strategies are not part of the financial advisors education nor part of the employee’s education programs at organizations throughout this country.
This pension legislation has only been in existence for approximately 14 years. As a society Canadians do not have long-term experience living under these rules. The market performance of the last 10 years has given many individuals a false sense of achievement. Due to the significant market correction in late 2000 and 2001, many have seen cracks begin in their nest eggs.
Diane Dekanic is president of Calgary-based Financial Health Management Inc. A fee only financial planning organization. She can be reach at 1-877-349-7337, [email protected] or www.fhminc.ab.ca.
The late 1980s and early 1990s were a time of significant pension reform across this country. Reforms included: earlier vesting provisions; portability of the pension funds; and the creation of defined contribution pension plans (DC) all hoping to improve retirement prospects for workers who, in all likelihood, will not enjoy a cradle to grave relationship with their employers.
These reforms were very meaningful, especially during a time of significant layoffs and changing labour markets in the Canadian economy. Prior to these reforms, employees were not vested in a company pension plan until 45 years of age with at least 10 years service. They simply lost funds accumulated from employer’s contributions toward their pensions.
The reforms recognized the movement of employees and the changing nature of the labour market. Provisions in the pension reform allowed terminating and even retiring employees to elect to change their participation from the traditional defined benefit pension plan (DB) to the DC plan or to commute the value of their pensions and transfer them to a locked-in retirement vehicle.
This movement from DB to DC and locked-in vehicles was welcomed by employees and employers alike but for different reasons. Employees welcomed the change for the ability to control their investments and employers for the significant reduction in cost and management.
Employees embarking on a plan transfer have generally been provided with financial planning assistance by the employer. The financial industry has responded in most cases with conservative estimation of what the income generation can be based on average rates of return so that employees can make reasonable estimations and decisions. Excellent guidance is generally provided by the sponsoring financial organization to employees with respect to investing, risk assessment and understanding the importance of diversification during the wealth accumulation period.
However, what has been lacking in this education process is how and when the income for retirement is determined. There is a significant misunderstanding by employees and employers as to how this is determined. In many cases, it is assumed that the income generated from the lock-in plans is similar or the same as Registered Retirement Savings Plans. This couldn’t be further from reality.
A majority of individuals are totally unaware of the income options at retirement from locked-in funds. More significantly, individuals over the age of 50 are increasingly commuting the value of their defined benefits pensions or electing to convert to a defined contribution plan in the expectation that they can “do better” with respect to the income that is produced from a defined benefit pension. Many have made these decisions with the assistance of a financial advisor.
Even with the best of intentions and producing projections at conservative rates of return, many financial advisor do not recognize the impact of variable rate of return on the income generation in future years.
Pension reform places significant rules that determine income flows to the annuitant. At the time of these reforms, legislators had seen more than two decades of interest rates exceeding 10 per cent per annum. Legislators did not anticipate low interest rates and that individuals would be induced to move to equity markets to improve the rate of return of the portfolio. What was also not anticipated is the mix of inflation and variable rate of return on the production of income.
For individuals who are not retiring and do not have to draw down their locked-in funds, market fluctuations are generally a “wait it out” activity. But what happens when individuals require the income to sustain them and don’t have the luxury of waiting out market corrections?
Let’s look at the options:
To generate an income from locked-in funds there are three options available, depending upon in which province you reside.
1) Annuity: which provides a guaranteed income for life at a fixed rate of return.
2) Life Income Funds (LIF): which provides annual income based on a minimum as well as a maximum formula. The minimum rate is usually calculated as the fraction 14(90 minus age of annuitant). For example if the annuitant retires at age 55 the calculated rate would be 14(90 - 55) which equals 2.85 per cent.
The maximum income each year is determined using: 1) the interest rate equal to six per cent for the entire term; or 2) the interest rate on long-term Government of Canada Bonds for the first 15 years and a maximum of six per cent thereafter. If the annuitant lives to age 80, the balance in the fund must be converted to an annuity.
3) Locked-in Retirement Income Fund (LRIF): which provides income based on a minimum as well as a maximum formula. The minimum rate is usually calculated as 14(90 minus age of annuitant). The maximum in the first two years is six per cent and then the previous year’s rate of return, established the maximum income flow.
This option contains the most danger for employees not prepared for the inherent risk involved in using a variable annual rate of return. (Available in Alberta and Saskatchewan, but being considered in other provinces.)
Most information made available to employees uses a conservative annual rate of return of six per cent.
However, the real concern is how in reality this income flows. Anyone who has been investing recognizes that an average rate of return measures the sum of the returns divided by the number of years that are being measured. In fact, the real rate of return that most individuals receive is more of a “Monte Carlo” rate, which means that actual rate of return varies from year to year. One year the rate of return may be a negative the next year 10 per cent, but on average may be six or eight per cent over the life of the plan.
This is only one example, but the ramifications hold through regardless of the random nature and the average rate of return used. There are strategies that can be employed with respect to managing these portfolios, but many of these strategies are not part of the financial advisors education nor part of the employee’s education programs at organizations throughout this country.
This pension legislation has only been in existence for approximately 14 years. As a society Canadians do not have long-term experience living under these rules. The market performance of the last 10 years has given many individuals a false sense of achievement. Due to the significant market correction in late 2000 and 2001, many have seen cracks begin in their nest eggs.
Diane Dekanic is president of Calgary-based Financial Health Management Inc. A fee only financial planning organization. She can be reach at 1-877-349-7337, [email protected] or www.fhminc.ab.ca.
