Q&A: Take Commuted Value or “Pension”? (Laid-off from Nortel in the summer of 2009)

Q: A friend of mine was in the latest round of (Nortel) lay-offs, and is trying to decide whether to take his pension as a lump sum, or stay in the plan. Of course, in the current mess, there is no company help in laying out the pros and cons. Can you recommend someone who can help him understand the trade-offs? (DC)

A: I don’t know who would be a suitable choice for giving you advice in such a very unique situation (I’ll explain later why so unique). Normally I would say is a fee-only financial planner might be able to look at your specific situation and evaluate the risks associated with the various choices. This may still be an option for you to explore. The Financial Post’s Jonathan Chevreau discusses fee-only planners in a recent blog. In that blog he also names names of such fee-only planners that he has come across (also look at the comments section where there are others mentioned or have written-in as well). You  can call a few of them and have an exploratory chat with them, and based on that you might find somebody you feel comfortable with.

Now back to the very unique situation that we now have with Nortel. The problem is that the issue here not just the CV vs. pension question, but you must guesstimate of the likelihood of various outcomes and as the saying goes not just the “known unknowns” but also the “unknown unknowns”.  While you are looking for an advisor, I’ll give you and your friend something to chew on; some of these are perspectives that you might want also discuss with an advisor you might ultimately select. Any thoughts/comments/counter-arguments  to the following are welcome.

Commuted Values: It was suspected that Nortel pension fund was around the 60% funded level already last year  (you can read about my various warnings/concerns in the top right hand Pensions box at this website RetirementAction.com). So given respectively 100% and 86% CV payouts until January and May of this year appear to have been no-brainers (at least in retrospect). In May, Nortel’s actuaries issued an “estimate” for the plan valuation of 69% effective December 2008. All new CVs were declared in May to be payable at 69%. (In fact, I believe that since early July, there may be new more stringent FSCO requirements before CVs may be paid from underfunded plans; not sure to what extent this may affect Nortel.). I questioned the 69% “estimate” due to possible optimistic actuarial assumptions and suggested that valuation may have been closer to 60% at the time.

How much is your pension: This is an important consideration because for those who have worked in Ontario there is a PBGF insurance fund run by Ontario government which guarantees the first $1,000/month of pension. So for somebody whose pension is not far above $12,000/year, sticking with the pension may lead an acceptable outcome. (I say this even though Premier McGuinty indicated that the insurance fund is also underfunded; but I suspect that the risk of Ontario government reneging on its obligations is low.)  If your pension is in the $50K range, the PBGF insurance is much less consequential in your decision making process.

Nortel is being dismantled: The current path is heading toward where Nortel will no longer exist as a going concern after some months (or years). The current law requires that the FSCO wind-up the pension plan and attempt to purchase annuities for pensioners with the available plan funds from one or more Canadian insurance companies. The annuity market in Canada is rather shallow and Canadian financial services market is not famous for competition (e.g. annual 2-3% mutual fund MERs, 3-3.5% GMWB fees, etc), but it would be fair to expect that the ultimate “funded” status, and therefore the resulting annuities will be determined not by Nortel’s actuaries or FSCO, but by the annuity pricing to be quoted by the insurance companies. Canadian annuities are expensive in general and (despite what you may think) insurance companies are not in the business of taking on risk (longevity, market or inflation), they are in the business of investment management and collecting fees. So you can assume that they will make conservative longevity assumptions, will price the annuity on the low-side of current interest rates (e.g. government yields) and if inflation protection will be included it will also be priced conservatively. Bottom line is that without significant additional funds being added to the pension plan (from the Court proceedings and/or government sources) the expected annuity may be closer to 50-60% than 69%  (see Too little, too late!- 50% interim CV payments would be more appropriate). (Of course we may be surprised here as well, if by some (unlikely) twist of fate Nortel’s Canadian entity is preserved in some scheme and the pension plan would be maintaned as a result. I wouldn’t bank this as a likely outcome; the government does not seem very responsive to RIM’s protestations against possible unfair play in bidding or protection of Canadian tax-payer funded intellectual property rights.)

Sources and amounts of additional funds to make up some or all of the fund shortfall: (1) The fund beneficiaries are creditors of Nortel who have a claim in the Court against remaining assets. Estimates on likely payout per dollar of claim may be as low as $0.10 to as high as $0.40 that some U.S. bondholders expect to recover. The reality is that the Canadian pensioners’ ultimate take is very difficult to determine, not because the existing cash and likely proceeds of asset sales are so difficult to assess, but because it is unclear if there are any assets in Canada and if/how the resulting cash from asset sales will be moved across borders (U.S., Canada, U.K. and other countries). So far since the bankruptcy protection, Nortel Canada had to provide collateral to borrow from Nortel U.S. subsidiary to be able to pay Canadian employees (WOW! How could management let this happens?!?). (2) The federal and Ontario governments have effectively bailed out GM Canada pensioners to the tune of about $3B; how could they not do the same for Nortel’s Canadian pensioners? Time will tell, but I wouldn’t bank it. (3) There is a grass roots push to increase priority of pension plan underfunding in the bankruptcy proceedings, relative to other unsecured creditors; this requires (emergency) changes to the BIA. Will it be done? And, will it be done in time to have impact on Canadian Nortel pensioners? Your guess is as good as mine, though so far the Conservative government has been resisting.

Other considerations: some (including myself) are pushing for combinations of “slow wind-up”, no compulsory annuitization, pensioners to have the option to take CV equivalent which is then managed as pooled asset with longevity insurance included. In my opinion and according to my calculations (see Doomed Nortel pensioners? Outside-the-box pension options and path to pension reform) this is expected to have a superior outcome to annuitization; perhaps of the order of 35% higher expected (not guaranteed) NPV given the life expectancy of a 65 year old pensioner. The annuitization also introduces the risk the insurance company not fully paying out the promised income over a  potentially 20-40 year lifespan. However persuading those with power to make this change (the Ontario government) is a long-shot.

A sample calculation: For a $12K annual pension, we will assume that it’s fully insured by PBGF (i.e. will stay at $12K). However for a $50K pension, only the first $12K is insured and let’s see what the impact of puts and takes are on the uninsuraed $38K. Assuming interest rate environment is unchanged from YE’2008 then starting from the Nortel “estimated” 69% funded level, one might reduce 7% points (10% reduction) for optimistic actuarial assumptions giving 62%, increase by 4% points (for a 14% increase in the equity portion of the assets due to higher levels of the Canadian market) moving to 66%, increase by 3% points (assuming a 10% creditor recovery in Canada) results in 69% and reduce by 7% points (10%) due to insurance company profit margin and conservative longevity assumptions leading to 62%. Then 62% of $38K exposed part of the pension is $23.5K. Add back the $12K insured and the $50K pension becomes $23.5+$12=$35.5K (or 71% of original pension) after all the puts and takes. With 62% of uninsured part recovered, the break-even to 69% CV is a little over $62K of original pension. You can plug in your own assumptions.

Bottom line: If one’s pension was around $12K or a “little” higher, then I suspect that staying with the plan would be a very clear decision (subject to your assessment of Mr. McGuinty’s threat that the insurance fund is not fully funded). Above that, the case for taking CV depends on the size of the pension and one’s assessment on the probabilities associated with the various upside outcomes mentioned above versus the possibility of being forced into an annuity with no additional funds flowing into the Canadian pension plan as a result of the bankruptcy proceeding. For those betting on the latter, 69% might sound good. For any level of residual assets in the plan, every $1 invested as a pooled asset with longevity insurance included is expected (not guaranteed) to result in about 35% higher NPV, given the life expectancy of a 65 year old pensioner, than an annuitized approach.

As the saying goes “Forecasting is difficult, especially about the future”. Who knows what the prevailing interest rates (for calculating liabilities) and pension assets will be when the plan is wound-up and annuities are bought? Or for that matter, how a pooled asset approach would perform over time or what damage inflation will inflict on a fixed annuity over 25 year retirement.

I hope this will help you with your decision.