In a Nutshell

Just passed the half way point in the Nortel annuity vs. lump sum decision, it’s time to review my current thinking on my personal decision. Prior to receiving the option letter I was heavily inclined to take the commuted value (lump sum) if it was reasonably close to the actuarial fair value, but given the extremely low value of the lump sum offered this would be difficult to justify. There is a good case to be made for taking the annuity, given it would be very difficult to match its effective return for unimpaired life expectancy without taking on significant portfolio risk that would be difficult to justify within the constraints of a LIF.

Background

Upon receiving the option letter, I approached a number of insurance companies to inquire about the cost of buying the annuity with a 60% survivor benefit using the lump sum offered. The quotes received offered an income stream in the range of 6.46-6.6% per year compared the annuity option of 7.95%. While this is not the governing criterion for the decision, it is an indicator that the lump sum is about 20% lower than market value. In a September 2013 blog post Nortel pensions: Why CV/LIF value is less than annuity value for Nortel’s Ontario pensioners? I discussed the reasons why Nortel pensioners’ lump sum offer was going to lower than expected (in my case it was about 10% lower when I wrote that 2013 post), however we are now another three years later (and 8 years after the actually declaration of bankruptcy) and the corrosive effect of the Ontario government specified punitive formula for pensioners caused an almost 20% lower lump sum offer compared to cost of buying the annuity today. The reality is that the use of such a punitive formula anchored on a October 1, 2010 theoretical windup date then aggravated by additional factors (a claw-back of pension received since windup, higher interest rates at windup than today, mortality improvements not recognized relative to windup date assumptions, and no recognition higher life expectancy of surviving pensioners in January 1, 2017 than 2010 simply due to passing of time) will result in significantly greater uptake of annuities than with a commuted value (or more appropriately lump sum) offer closer to fair/market value. (I haven’t seen the option letters of deferred pensioners but since there is no claw-back for them by virtue of not having received pensions as yet, the CV/lump-sum should be more attractive.)

Early in October we also were informed that the expected recoveries for Canadian creditors will be in the range of 46-48% of the claims. (Surprisingly close to the guesstimate 44-51% for Canadian claims in a July 2015 post Reflections upon Nortel’s Canadian pensioners’ prospects: July 2015 view. But it’s not over until the money is in your account. Believe it or not even at this late stage of the game dissatisfied creditors like the US Pension Benefit Guaranteed Corporation has have raised new objections as described in Nortel Networks, pension group battle over $7.3-billion in assets .)

There appears to be considerable confusion as to what the funded level of the pension plan will be for pension plan members in various provinces (we heard number ranging from about 59% to 77% depending on which province the pension finished his service) but the numbers are usually comparing apples to oranges. Furthermore, the funded level per se is not a governing factor in the annuity vs. lump sum decision; the key decision factor is the comparison of the potential financial outcomes between choosing the annuity and commuted value. At the risk of further adding to the confusion the approximate declared funded level on theoretical windup date was 59%; i.e. for each $1.00 of annuity promised by the pension plan one could only buy $0.59 of annuity income at windup from available funds in the pension plan on windup date. So 59% is the funded level of the pension plan including the partial indexation included in this plan. Ontario pensioners are supposedly getting 77% on this round (including the Ontario PBGF insurance on the first $12,000/year pension (about a 10% kicker) and loss of indexation leads to about another perceived 10% kicker), but that is comparing apples and oranges, since Ontario pensioners will lose indexation. So getting a 45% recovery on the 41% shortfall suggests that there under this scenario there are sufficient funds to cover 59%+ 45%x41%=77.5% for everybody, but Ontario pensioners will perceive this to be about 92% (factoring in loss of indexation and a (smaller) PBGF contribution.) In reality, everyone will effectively get about 77% of the value of the original indexed pension and Ontario pensioners will receive about an extra $1,500/year to compensate for the effective shortfall on the first $12,000/year. Individual percentages will be a function of individual pension levels.

During the Nortel negotiated plan member’s decision period I tried to summarize the approach that I would use to make the decision in a December 2015 blog post Will that be annuity or lump-sum?. That is still the basis of my decision process currently.

So, why I am now inclined toward the annuity rather than the lump sum offered?

My circumstances do not require an annuity to meet my current fixed and discretionary expenses, I need little (<8%) or no allocation to stocks to meet expenses and (while nobody has any guarantees my health situation suggests that) it appears reasonable/conservative to assume average life expectancy. However assuming conservative capital market expectations:

–Commuted Value too low: CV is 20% lower than fair market value of such an annuity suggesting the need for a deeper look into the available options.

–Annuity requires no investment management: annuity is much easier to manage (in fact no management is required) than the LIF alternative, should one become incapacitated mentally and would not be able to manage investments or spouse is unwilling/unable to manage herself.

–Ontario government guarantees lump sum and annuity: values stated in the option letter (at least until annuity is issued by an insurance company) are guaranteed. If issuing insurance company fails to make good on annuity payments, it is backed up by Assuris up to $2,000/mo or 85% of annuity income, whichever is higher. Nortel pension administrator, Morneau- Shepell, will allocate annuity purchases among sufficient number of insurance companies so that pensioners can get full Assuris coverage of their annuity. (Of course if there is a systemic financial event which affects the entire financial industry the Assuris coverage may also be affected.)

–Annuity is a better deal: Internal Rate of Return (IRR) of the annuity income stream given the CV offered  is about 4.75% to my life expectancy (about 17 years) at 100% payout and additional years of joint life expectancy (total 22 years) at 60% payout for my spouse. This compares very favorably to available investment grade fixed income investment opportunities of 2-3% that might be bought for the LIF. Higher income individuals and those with higher education have even longer life expectancy as compared the Social Security mortality experience upon which the IRR was based. Of course annuity payout continues for life and 25^th percentile longest male/joint life expectancies are another 5-6 years longer than above, giving further upside to the annuity. (By the way, if lump sum offered would be equal to market value of the annuity (i.e. 20% higher) then the corresponding IRR would be a much more achievable 2.5% with current reality of investment grade fixed income securities, making the lump sum a more realistic alternative.)

–LIF would require risky/inappropriate stock allocation to deliver return similar to IRR of annuity: to achieve IRR anywhere close to 4.75% one would have to allocate about 60% (using conservative capital market expectations) into stock which is higher than my estimated risk tolerance (50%) if I took the lump sum. Also, in case of my circumstances taking the annuity increases the risk tolerance allowing the stock allocation to increase from 50% up to about 80%. Furthermore by putting stocks into the registered (tax-deferred) LIF transforms much lower taxed capital gains into higher taxed income (which really doesn’t make sense).

–Minimum withdrawal requirements during significant market downdrafts would aggravate LIF depletion: The minimum/maximum required/permitted withdrawals in Ontario LIFs at age 70 are 5.0%/8.22%, at age 75 5.82%/9.71%, at age 80 6.82%/12.82%, and at age 85 8.51%/22.4%. Having a significant allocation to stocks in the LIF, one is exposed to the associated volatility of the portfolio. Should the market have a significant downdraft over 1-3 year period in retirement can lead to a seriously depleted LIF due to market losses aggravated by required minimum withdrawals (or even worse if higher than minimum withdrawals might be required to meet expenses), so that the LIF value might erode to the point that it would not be able to recover adequately when an improved market conditions follow, thus resulting in a permanently depleted LIF and a corresponding lower LIF payout.

–12 year breakeven to recover CV offered: it would take only about 12 years to break even between the lump sum and annuity income at 100% which is not far off the 9 and 11 year 75^th percentile life expectancy point (i.e. 75% of the cohort is still alive)

–Maximum permissible transfer value to LIRA/LIF– if commuted value exceeds the maximum permissible transfer into a LIRA or LIF the excess is taxable as income. For those for whom this is the case based on current CV offered (and a possible further 46-48% additional recovery on the unfunded pension claim from bankruptcy settlement) the impact of the tax payable must be considered as well.

–Monte Carlo simulations also indicate superior outcomes with annuity: simulation indicates superior outcomes can be expected at 5^th and 75^th percentile points of income and residual assets.

Potential downside of taking the pension/annuity

–Inflation increases dramatically compared to current levels of <2%. While significantly higher inflation (and interest rates) is a possibility, current expectations based on demographic realities tend to suggest lower/similar rather than significantly higher inflation/interest rates.

–If pensioner dies amongst the first 25^th percentile life expectancy of 9 and 11 years for average and excellent health individuals, respectively which is close to 12.5 year breakeven on an undiscounted cash received basis at 100% level; also if both pensioners die among the first 25^th percentile joint life expectancy point at 18 and 20 years respectively for average and excellent health couples. These are possible outcomes but if both are dead then they won’t miss the lost income.

Bottom line

There is a good case to be made for taking the annuity, given it would be very difficult to match its effective return without taking on significant risk that would be difficult to justify within the constraints of a LIF