KEEP YOUR PENSION OR TAKE THE COMMUTED VALUE?
Leaving your employer before retirement can force an important financial decision if you participate in a defined benefit (DB) pension plan. You can either keep your pension or transfer out its lump sum commuted value.
This choice could be significant if you’ve been with your employer for a long time.
WHAT IS A COMMUTED VALUE?
The commuted value is the lump sum settlement offered to you in lieu of retaining your pension. It’s calculated as the expected present value of your pension using several assumptions, such as interest and mortality rates.
Most pension plans calculate commuted values using the methodology prescribed by the Canadian Institute of Actuaries (CIA). The interest rates utilized are based on yields available on high-quality provincial and corporate bonds. The mortality assumption is based on experience from Canadian pension plans.
The interest rate used to calculate commuted values in June 2023 is approximately 4.4% per year. In 2023, the life expectancies at age 65 calculated from the CIA mortality tables are 22.7 years for men and 24.9 years for women.
Consider 54-year-old Lisa, who is entitled to a monthly pension of $7,000 per month starting at age 56 (the age she qualifies for an unreduced pension due to her long service). Her pension plan offers her a commuted value of $1,387,000, calculated in accordance with the CIA methodology.
This is the amount that is being offered to Lisa to leave the pension plan. She can take it or leave it.
OPPORTUNITY VERSUS RISK IS A MATTER OF PERSPECTIVE
The decision to retain or commute your pension depends, in part, on your perspectives on risk and opportunity.
Your retirement income will be more predictable if you keep your pension. Stock market losses and volatility will be your former employer’s problem, not yours. On the other hand, you might be able to generate higher retirement income if you skillfully invest your commuted value.
The remainder of this document discusses some of the other factors you may wish to consider in your decision.
WHAT ELSE MIGHT YOU BE GIVING UP IF YOU TAKE THE COMMUTED VALUE?
Some employers provide benefits to former employees that are only available if you choose to receive a pension. Those who take the commuted value might be passing up on these additional benefits.
For instance, some corporate pension plans provide discretionary cost-of-living increases to pensioners when they can afford to, but this is not a contractual commitment and is therefore not capitalized in commuted values.
Post-retirement health benefits might also be available to you if you keep your pension, but not if you take the commuted value.
Read your pension plan booklet and talk to your Human Resources contact to understand what you might be giving up if you take the commuted value.
TAX LIMITS ON COMMUTED VALUE TRANSFERS
The commuted value of your pension can be transferred tax-free into a Locked-in Retirement Account (LIRA) up to the age-based limit prescribed by the Income Tax Act (ITA). Any amount above this limit is taxed as ordinary income in the year received.
Continuing with our example above, the amount that Lisa can transfer to a LIRA is:
The after-tax commuted value Lisa receives is as follows:
The portion received in cash is added to Lisa’s income and pushes her into the highest tax bracket, such that the average tax rate on Lisa’s excess commuted value is 45%. In addition to this one-time tax, all future investment gains on the cash received are also taxable. If Lisa has unused RRSP room available, she can use it to absorb some of the taxable portion and thereby alleviate this tax burden.
The bottom line is that if a portion of your commuted value is taxable, you’ll need higher investment returns to make up for the immediate tax consequences as well as the ongoing tax drag from investing outside of a tax shelter.
HOW SECURE IS YOUR PENSION?
Guaranteed monthly income from a pension plan can bring enduring peace of mind. But not all pension promises are equally valuable. What if your former employer goes out of business?
There are strong protections for pension plan members in Canada, but corporate pensions aren’t guaranteed income. There is a possibility you won’t get your entire pension if your former employer goes out of business and the pension plan is underfunded. The magnitude of this risk depends on the funding level of your pension plan, the creditworthiness of your former employer, and the nature of its business.
You can reduce your single company risk by taking the commuted value and investing in a diversified portfolio of securities. That way, the failure of one security out of hundreds (or thousands) in your portfolio shouldn’t have a noticeable impact on your retirement income.
YOUR PERSONAL HEALTH
Commuted values are calculated assuming you are in better health than the typical Canadian (members covered by pension plans are healthier, on average, than those who aren’t). Using the prescribed CIA mortality tables, a 65-year-old man and woman in 2023 have a total life expectancy of 87.7 years and 89.9 years, respectively.
It’s possible that your commuted value understates the true value of lifetime income if you have a family history of living into very old age. If this describes you, it might be to your advantage to keep your pension to exploit your health advantage.
On the other hand, the commuted value might overstate the value of lifetime income if you have a medical condition that reduces your life expectancy. In this case, it might make sense to take the commuted value.
The bottom line is that you may have information regarding your specific circumstances that could be used to your potential financial advantage.
You might be invested too conservatively if your portfolio asset mix doesn’t reflect the amount of secure income you have from the Canada Pension Plan (CPP), Old Age Security (OAS), and employer-provided defined benefit pensions.
Pensions are like income from a fixed-income portfolio because they provide predictable fixed payments, just like bonds. In fact, pensions are better than bonds because they also come with a longevity guarantee.
An actuarial balance sheet capitalizes your pensions to provide you with a more accurate view of your asset mix, which in turn might help you make better investing decisions.
Let’s look at Lisa’s actuarial balance sheet immediately upon retirement. Her invested portfolio is worth $1 million and is invested in a 50/50 balanced portfolio. In addition to an employer pension, Lisa will also receive CPP and OAS. Lisa’s after-tax actuarial balance sheet might look something like this:
Precision is not important in estimating the present value of your pensions. Using reasonable estimates for life expectancy, bond yields, and taxes will do the trick. In this example, we’ve assumed all pension income will be taxed at 30%. Lisa’s after-tax pension is therefore estimated to be worth $971,000 (=70% of $1,387,200).
If Lisa chooses to keep her pension, she might contemplate increasing her equity allocation considering that almost 77% of her financial assets are presently invested in bonds and bond-like pensions. On the other hand, a 50/50 portfolio might continue to be appropriate if she chooses to commute her pension.
Finally, had Lisa understood her true risk exposure all these years, she might have invested significantly more in equities all along.
SECURE INCOME VERSUS SPENDING FLEXIBILITY
You may wish to consider security versus flexibility when evaluating your decision to take a commuted value or retain your pension, as discussed here.
If your entire financial net worth is in the form of monthly income, what will you do if you have a large expenditure? On the other hand, you might feel vulnerable if too much of your wealth is directly exposed to the uncertainty and volatility of capital markets.
Taking the commuted value will likely give you more spending flexibility, but keep in mind that you cannot access your funds until you convert your LIRA into a Life Income Fund (LIF). The minimum age for establishing your LIF is either 50, 55, or none, depending on the jurisdiction of your pension plan.
With a LIF, there is a range of permitted withdrawal rates that will likely provide you with more spending flexibility than if you kept your pension. Furthermore, if your pension jurisdiction is Alberta, Saskatchewan or Federal, you might be eligible to unlock up to 50% of your commuted value into an RRSP when you convert your LIRA into a LIF. There are no restrictions on how much you can withdraw from an RRSP each year so can you use these funds for purposes other than generating retirement income if you choose.
PENSION INCOME SPLITTING
The Income Tax Act allows married couples to split pension income in retirement. Pension income is defined as income from a defined benefit pension plan at any age1, or money paid from a RRIF/LIF after age of 65. You can read more about income splitting here.
If you were considering retiring early, taking a pension could be a way to reduce your overall tax burden during retirement. It depends on your circumstances.
YOUR QV INVESTMENT COUNSELLOR CAN HELP
Whether to commute a pension is a personal decision that depends on numerous factors, a few of which we have discussed here.
To learn more, contact a QV Investment Counsellor who can help you examine your specific situation.
1 except in Quebec where you must be 65