Keith, a professional firefighter for the past 22 years, is considering a career transition from public service to the financial services industry. For the past few years, he has been developing skills in the field of investments in his spare time, completing courses at the Canadian Securities Institute in order to receive the Canadian investment manager designation.

I raise Keith’s case because, like many public-service employees with gold-plated pension plans, he has been on the receiving end of a scheme I call the “commuted value manoeuvre.” The idea, promoted by various financial advisors, is for employees to take their share of the accumulated assets from their pension plans (Keith is a member of the Ontario Municipal Employees Retirement System) and transfer it into individual pension plans or, for younger members of a plan, into locked-in retirement accounts.

The appeal of the commuted value manoeuvre is that the employee receives a sum significantly greater than the amount that was deposited into the plan over his or her employment history. Whether that money ends up in an IPP or a LIRA is not as important as the implications of the manoeuvre.

One implication is the inheritance provision. If the assets remain in the plan, the employee’s surviving spouse receives “only” 66.6% of the employee’s pension income upon death, which would be paid until the spouse dies.

At that point, the remaining assets — if there are any — would revert back to OMERS for the benefit of other pensioners. With the commuted value option, the pensioner owns the assets and, upon death, they flow to the estate and to the surviving spouse or children. For some, that is appealing.

On the other hand, owning the assets means managing them. As the employee receiving the commuted value is probably working with a financial advisor, that will ultimately be the advisor’s responsibility. As these assets are meant to deliver an inflation-adjusted income for life, that is a long-term commitment.

There is also the issue of government-imposed rollover limits to the maximum amount that can be transferred tax-free into an IPP or LIRA. Amounts above the rollover limit — and almost all gold-plated plans will have excess capital — are treated as taxable income in the year it was received.

So, what value does one place on commuted value? Most employees erroneously believe commuted value is the money the employee deposited into the plan, plus the money the employer deposited into the plan, plus growth of that money when it was in the plan.

In reality, commuted value is the amount of money the pension plan would have to set aside at the time of the employee’s retirement, to pay — as in the case of OMERS — an inflation-adjusted monthly income stream to the employee during his or her retirement years.

The calculation uses the same assumptions any investor would: the expected rate of return, the cash-flow requirement, the time horizon and the tax implications.

The tax implications take us back to the rollover limits. When calculating commuted value, the plan administrator assumes all the capital would flow through tax-free — which is what would happen if the money stayed inside the pension. Given that, the after-tax amount that represents the commuted value payout will always be less than the true liability calculated by the pension plan administrator.

The commuted value return assumption is fixed and can usually be provided by the plan administrator. The cash flow is known. Inflation assumptions can be a variable, although most plans have upside limits.

In terms of time horizon, the plan administrator is interested in how long it will have to pay income to the employee, as well as a reduced pension to the surviving spouse. That part of the calculation takes us into the world of actuaries, who come up with life expectancy assumptions for all plan members.

In summary, when taking one’s commuted value, taxes are detrimental, return assumptions are fixed and life expectancy is a variable. Because life expectancy is a variable, employees taking commuted value never know if the amount of money they receive is too much or too little.

This is because actuarial assumptions only work when spread across large numbers. They have no value in terms of setting aside an appropriate amount for a single employee, as life expectancy of one employee will probably be different than the average life expectancy of a large number of employees.

@page_break@If the employee dies two years after opting for the commuted value, the money received from the plan was too much. For the pensioner — or, more important, the estate — that’s a best-case scenario. (Although dying early can hardly be seen as a best-case scenario.)

On the other hand, the employee could live to be 100, in which case the commuted value would be too little. Under that scenario, the employee would have to ramp up the return assumption, which means constructing a more aggressive and riskier portfolio.

Should Keith take the commuted value? He has investment knowledge. He believes in the concept of asset mix first, sectors second and individual stocks a distant third — critical assumptions in managing pension assets.

He also likes the idea of managing his portfolio because if he can successfully manage the commuted value inside a LIRA, the portfolio has the potential to grow to a size that will enable him to replicate the income that his unreduced pension would have provided had he remained with the fire department until normal retirement age.

On the surface, if anyone should take commuted value and invest it, Keith seems a likely candidate. However, the decision is not about how good you are at managing the assets, but rather on how the plan calculates the amount you will receive to manage.

What you receive is beyond your control; should you live a long, healthy life, you may have to hold a more aggressive portfolio to achieve the same result your pension plan would have — no matter how long you lived.

That flies in the face of conventional risk management, which is designed to solve problems, not create them. IE