As clients reach the age of retirement, they may seek advice from their financial advisers (FAs) about commutation of their work pensions. FAs should take great care before recommending this as a solution. Here is why.
What is Commutation?
In commutation, the retiring employee releases the pension plan from all claims in return for a cash payment that is advanced to a “Locked-In Retirement Account” or LIRA. This is similar to an RSP, but generally not cashable except in periodic instalments. The employee will likely also receive a taxable cash payment that can be rolled into an RSP, if there is "room".
Often there is little RRSP contribution "room" (where the taxpayer has made use of all contributions allowed to date) because of the pension contributions. After commutation, the risk is that the individual may outlive the capital. This financial disaster can happen as a result of high fees, poor investment returns, and poor financial management such as large withdrawals.
To make their case in favour of commutation, FAs typically present return scenarios to clients that suggest the private investments should outperform pension benefits. These scenarios often prove to be misleading and inaccurate.
FAs may raise the risk of underperformance implicitly. They often say, “Past results are no assurance of future returns.” They then go on to say that they have a special sauce to get higher returns than what the markets usually earn. The FA’s warning is often vague. It is usually ignored, overridden by promises made orally by the FA.
This is a known communications risk, which the FA must overcome in order to offer effective advice. Clients depend on their FAs for advice. FAs risk being found liable, if they abandon their professional responsibilities and become “salespeople” by failing to communicate risk effectively.
Interest rates have dropped steadily since the 1990’s. In the modern era, retail private investments usually underperform pensions, and with greater volatility. To outperform, FAs implement high-risk strategies, using investments that are volatile and which clients cannot understand. Questions that are relevant to this dilemma are:
§ When did the FA determine the client should have higher-risk objectives?
§ Are these suitable alternatives to a secure pension?
§ What capital protection is there for a poor investment strategy?
Few clients are able to assess the risks and determine the suitability of the commutation option, which involves complex math. For example, very rarely will commutation be suitable for a government employee, because the risk of default is close to nil and in many cases the periodic pension payouts are indexed.
FAs say that the balance of the client’s capital will be available to their estate on death. They ignore the survivor benefit of the pension, the availability of term life insurance and the risk that the capital will be exhausted before death.
Few FAs are sufficiently qualified to assess the relative risks and benefits associated with commutation, because they likely cannot quantify them. This complex option cannot be explained to any but the most sophisticated of clients. Therefore, most clients cannot provide informed consent. FAs may be held accountable for any financial failure.
Conflict of Interest
FAs should also be aware of the potential conflict of interest, when they are well compensated for the commutation. In the event of a financial disaster and subsequent law suit, the courts may well ask, “Who benefits?” In this case, it will clearly be the FA, who has been well compensated, not the client, who has lost investment money.
If your client requires timely and effective legal advice from the experienced lawyers at MBC Law Professional Corporation, we are professionals who are already on your side. Contact Harold Geller or John Hollander toll-free at 1-888-288-2033 ext. 234 or by email.