# Asset Allocation for Retirement-Include Commuted Value?



## fraser (May 15, 2010)

Someone recently suggested to me that when reviewing my porfolio with a view to allocation between equity, bonds, etc. I should include the current commuted value of my company DB pension (full pension in 2014). I have absolutely no intention of taking this communed value. This DB plan was closed at the end 2010. Including this value would essentially serve to increase my exposure to equities. If included, the commuted value of the DB pension would approx. 20 percent of my portfolio. Is this a common approach/practice.


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## MoneyGal (Apr 24, 2009)

It isn't necessarily a common approach, but it is a recommended approach. If you have a DB pension, you can "afford" to take on more risk with the rest of your portfolio and, in fact, it is rational to do so.


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## MrRed (Mar 22, 2010)

*PV of CPP*

What about using the present value of your CPP for allocation purposes?

If so, what discount rate would be most appropriate?


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## fraser (May 15, 2010)

Thanks, at first we were not certain about this but on reflection it made sense. We will move in that direction.


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## andrewf (Mar 1, 2010)

Your personal discount rate can be a matter of taste. Most accurately you'd need to value your CPP as a deferred annuity. 

I'd discount CPP at around 3 or 4% since it is low risk and indexed to inflation.


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## MoneyGal (Apr 24, 2009)

The current discount rate for indexed annuities is 4%.


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## Square Root (Jan 30, 2010)

This is the approach that I use. I wouldn't bother with CPP as it is a fairly small amount. My DB pension will be about 50% of my pre tax retirement income, so my portfolio is all equity. This gives me an approximate 50/50 asset allocation between equities and fixed income. This is pretty agressive given my age (60) but since we could live on the pension it seems ok to me.


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## Brian Weatherdon CFP (Jan 18, 2011)

*using commuted DB value in asset allocation*

Great discussion -- yes DB pension could be taken as "fixed income" and therefore increase equities in one's portfolio. 

BUT it depends on how "funded" the DB pension is. Many pensions remain 20% to 40% underfunded. Rising markets have difficulty fixing this problem because pensions have high ongoing liabilities (pensioners receiving income) and non-equity investments. 

SO consider using only 80% of the expected DB pension in your planning....on the belief that many DB pensions may pay less than promised, but most should be able to pay at least 80% of what has been promised.


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## sags (May 15, 2010)

Welcome to the forum Brian,

Good point you made regarding pensions.

A lot of news report get hysterical when discussing possible weaknesses of DB pensions, and leave the impression people lose all their pension benefit. 

In reality, most people who find themselves in an underfunded pension receive all their benefits, unless the plan is wound up, because contribution adjustments are also made, but some may be subject to some percentage reduction. 

If pension funds are losing substantial amounts of money, it is probable that those with private retirement investments have also lost a significant amount of their money as well.

If stock markets are down, everybody is getting clobbered.

Absence some fraud, I don't think a DB pension plan can go totally broke.

They must hold "something" in their portfolio, one would imagine.


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## Square Root (Jan 30, 2010)

If you discount your DB pension to recognize possible future shortfalls, it would also be consistant to take a reserve against future Fixed Income default. For some higher yield corporate bonds this might be significant. I agree with sags that pensions aren't as risky as the press would lead you go believe. Certainly not 20% risky. If the company is solvent the pensions almost always get paid in full.


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## OhGreatGuru (May 24, 2009)

Square Root said:


> This is the approach that I use. I wouldn't bother with CPP as it is a fairly small amount. My DB pension will be about 50% of my pre tax retirement income, so my portfolio is all equity. This gives me an approximate 50/50 asset allocation between equities and fixed income. This is pretty agressive given my age (60) but since we could live on the pension it seems ok to me.


I think you are confusing monthly income with asset allocation. If your DB pension will be 50% of your income, that doesn't mean your current asset allocation should be 50% income.

I have a technically complex paper by an actuarial group with formulas for estimating an equivalent fixed asset value for a monthly DB pension. It is essentially (Annual Pension) x (a Pension Factor) . The pension factor, if memory serves me correctly, can vary from about 12 to 17, depending on whether or not the pension has spousal survivor benefits, whether or not it is indexed, and other factors. But a lot of financial calculators use 15 for simplicity.

So Equivalent (Fixed Income) Asset Value = 15 x Annual Pension = 180 x Monthly Pension 

As most DB pensions feature integration of benefits with CPP, you usually ignore CPP.


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## MoneyGal (Apr 24, 2009)

OhGreatGuru said:


> The pension factor, if memory serves me correctly, can vary from about 12 to 17, depending on whether or not the pension has spousal survivor benefits, whether or not it is indexed, and other factors. But a lot of financial calculators use 15 for simplicity.


The other major parameter affecting the annuity factor calculation is the long-term interest rate. 15 is a little high in today's interest rate environment. (Signed, a person who works with IPAF - immediate pension annuity factor - and DPAF - deferred pension annuity factor - calculators all day.)


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## fraser (May 15, 2010)

I have decided to take the commuted value in to the equation at a more conservative number than the current buyout because of interest rate fluxtuations. The 'interest risk adjusted' commuted value of the DB will only constitute 17 percent of my retirement assets (DB pension in, house value out). Cheers


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## Brian Weatherdon CFP (Jan 18, 2011)

*Example... >35% loss in DB*

Actually the risk can be higher than 20%. One of my retired clients has a DB plan that had promised >$3000 monthly but he is now receiving near $1960 monthly, for a loss near 35%. 

Another DB plan with which I'm familiar is short $31 Million (last look was $180M but somehow 31 is now missing). Change of actuarial assumptions? Probably. However the impact will be a sharp reduction in pensions.

DB pensions cannot easily recover such losses. 

Commuting (for some people) is the option that offers you control of the money & asset allocation, and preserves value for spouse/family, or even as a Trust for grandchildren.


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## Brian Weatherdon CFP (Jan 18, 2011)

Hi Sags and Square Root.... Well the future is different than the past. I know a person who expected over $3000 monthly pension income and the result he's now receiving is slightly under $2000 -- so he has taken a loss in what people generally figure is guaranteed. I broadly estimate 20% potential drop in pension pay-outs. ... But this also is because I'm looking ahead demographically where western countries' greatest liability (including Canada of course) is seniors' pensions and health care. As baby boomers age there will be decreasing capacity to compensate for pension fund shortages. Pension fund trustees have a most difficult job to secure future pay-outs amid ongoing liabilities, rising interest rates jeapardizing capital value in bond investments, and the ultimate risk of longevity among their plan members. 

I could elaborate but that's it in a nutshell.


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