Updated: Jun 17, 2019
A common decision we see among our clients is determining whether or not to commute their defined benefit pension plan offered through their employer. The question typically arises from a change of employment, whether it’s retirement, a new job, or a loss of one. Clients often come to us expecting a clear-cut answer, and there very well could be depending on your individual circumstances. With that said, you’re going to want to consider several key factors in order to make the best decision possible.
If you’ve been with your employer for some time, chances are you’ll have a large amount within the pension plan. How important the decision will be depends a lot on how much of your retirement income the pension represents. Regardless, the first step towards making a decision is to gather the appropriate information. You will receive a letter and package from your employer that will outline pension options as well as a required decision date when a change of employment occurs. The decision date is important because if you don’t make a decision, the pension administrators will make it for you.
So what are the options available?
There are really four basic options. One, you can decide to stay in the company pension and receive monthly benefits. This usually comes with different options on guarantees of income and survivorship benefits. Option two, you can opt to purchase an annuity that pays a set cash flow at predetermined date in the future (similar to how you’d be paid by your pension). Third, you have the option to “commute” your pension to a locked-in retirement account (LIRA). Once in a LIRA you assume full control of the investments and how they are managed. Growth is tax sheltered and no tax is paid until you convert your LIRA to a LIF and begin to draw income. The last option available is requesting to have your pension transferred to another employer pension plan and participate there.
Desire to leave an estate behind -With pensions you typically have a choice of survivorship benefits. Survivorship benefits determine what your spouse will receive if you were to pass. The higher the amount your spouse is entitled to, the lower your monthly benefit will be while alive. The most common options we see are 1/2 or 2/3 survivorship benefits, where your spouse would receive half or two thirds the monthly benefit that was being provided.
It’s important to highlight that survivorship benefits are not the same as an estate value. Upon your spouse’s death, the money within the pension would not be a part of your estate and any family left behind would be entitled to nothing. Leaving an estate value is often one of the most important factors our clients consider and is one of the main contributors in the decision to commute their pensions. If leaving something behind is important to you, commuting your pension will ensure an estate value is left behind. Health often plays a roll in this as well. When we have clients with poor health or history of family illness, the decision to commute becomes more likely.
Control and Flexibility versus Guarantees - Commuting a pension puts you in charge of your assets. For many this is very much what they prefer. Retirement projections and monthly benefit calculations are often based on a level income (increasing with inflation). However, we know that as we age retirement changes, with early years looking very different than later years. Often, we’ll see with earlier years retirees needing a higher income to fund an active retirement with spending slowing as they age. Commuting a pension provides a lot more control in determining the income you receive through retirement.
On the flipside, many investors have a hard time taking on the responsibility of managing their own money. They fear the markets up and down movements and because of this would prefer to lock in a guaranteed set income. If this is you, staying with your pension or exploring the annuity option may be your best bet.
Taxes –Although you ultimately will pay tax on pension income one way or another, you should be aware that when commuting a pension there can be a portion that is unable to be transferred into a LIRA. This portion is added to your income for the calendar year. If you were to maintain the pension, you’re only going to pay tax on the income you receive each month. If many of the considerations mentioned are pointing towards commuting, the taxes you will pay on the portion that can’t be placed into the LIRA are typically not significant enough to change the decision to commute. On top of that you may have unused RRSP room that can be used to offset the income.
Financial Stability of Employer- If the financial stability of your employer is in question it may be in your best interest to take the commuted value. In bankruptcy situations or corporate takeovers, changes to pensions are not out of the question. Sadly, with bankruptcy situations, many hard-working employees can lose life savings and in the worst cases, receive absolutely nothing.
How well is the pension funded? You’re seeing less and less defined benefit pension plans being offered today for the sole reason that with a defined benefit plan, the responsibility is on the employer to fund the benefit from retirement for life. Most defined benefit pensions are dated and as a result, projections are based on old mortality tables and have not adjusted to increased life spans. The investment environment has also played a major role in squeezing pensions. Pensions are often required by law to hold a certain portion of long term extremely safe investments. That’s despite the fact that in today’s environment they provide very little in the way of returns, with many having trouble to keep pace with inflation. If your pension is underfunded it may make sense to commute it.
Are your benefits indexed? Many pension plans have built in mechanisms that increase the amount of the monthly benefit you receive (typically by 1%-2% per year). The idea here is that costs of goods and services will rise over time, and the income you need in retirement will also need to rise in order to maintain your current standard of living. The higher the indexing of your monthly benefit, the harder it is to make a case for commuting your pension. This is because in commuting your pension, you take on the responsibility of growing your investments to meet your future needs. In order to provide the same benefit as the pension, the required rate of return you need to achieve becomes higher with higher indexed benefits.
Income Splitting– If you’re taking your pension before 65 and your spouse is in a lower tax bracket, you can opt to split the pension to take advantage of your spouse’s lower tax bracket. If you decide to commute your pension, you’ll need to convert that pension to a LIF to be able to draw an income. In order to income split the amount received from your LIF, you’ll have to wait until the age of 65 (your spouse can receive the income regardless of their age).
Is there an option to maintain your health and dental benefits? Some company pension plans allow retirees who stay within the pension to maintain their health and dental coverage in retirement. In this situation you’d want to weigh the cost required to obtain private health coverage in order to determine what’s best for you. If you’re changing employers or were let go, this will not be something that you need to consider.
In closing, one thing that should be noted is that the financial services industry is notorious for convincing pensioners to commute the value of their pension. Advisors (myself included) are typically compensated based upon a percentage of the amount of money you have invested. Commuting the pension means more money for your advisor. Avoid advisors who only focus on selling you the benefits of commuting, or who make comparisons using rates of returns any higher than 5%. Although a 5% return or higher is achievable, the current investment environment makes it far from a guarantee. This would be a red flag for me, suggesting that the advisor is knowingly or unknowingly putting their interests ahead of yours.
As you can see the decision surrounding your companies defined benefit pension plan needs to take a lot into consideration before being made, with the above being only a few of those considerations. There is no right answer. If you’re working with an advisor, they should focus on having conversations around these considerations and provide advice based upon your individual circumstances. That’s Smart Money.
-Brandt Butt, Investment Advisor
Brandt Butt is an Investment Advisor at award winning firm Endeavour Wealth Management with Industrial Alliance Securities Inc. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Brandt Butt who is a Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.