Should I take the commuted value of my pension?
Breaking up is hard to do.
Or is it – when it comes to your employer?
Whether that is voluntary leave or involuntary leave, at some point, some people are faced with a very important financial decision: should I take the commuted value of my pension?
This post will hopefully provide some insights, based on a reader question, including my own situation with my pension to share any considerations as food for thought!
I already have a very detailed post on pensions including the introductory basics on my site so I won’t repeat all details here, but I think it’s very important to understand there are two main types of pensions that we’ll talk about today:
- Defined Contribution (or DC for short), and
- Defined Benefit (DB).
Think of your DC plan just as the words sound – your contribution is defined but ultimate pension value is not. Meaning, there are no promises. You’ll get what you’ll get based on what you invest in and the returns of what you invest in over time.
Think of your DB plan this way – your (pension) benefit is defined – meaning your pension value at the end of the line is known, usually based on a formula with your company that goes something like this:
Best Average Five Years’ Salary x Benefit Percentage x Years of Plan Membership = Annual Pension Income
So, using real numbers it could be this for some:
$60,000 x 1.5% x 25 = $22,500
Here is a quick pension comparison summary worth noting:
|Defined Contribution (DC) Plan||Defined Benefit (DB) Plan|
|Philosophy||Assisting employees accumulate retirement savings during their career.||Rewarding long-service employees with a lifetime retirement income.|
|Investment Decision||Employees decide how contributions are invested in (usually) a limited number of funds.||Professional money managers look after investment decisions based on strict guidelines.|
|Investment Risk||Employee bears the investment risk (since they selected the investments).||Employer bears the investment risk.|
|Income at retirement||Based on employer and employee contributions and investment performance.||Based on a formula that includes your annual earnings and years of service.|
|Valuing Your Pension||Simple, as employees have their account balance readily available.||Difficult, the commuted value is not readily available for most pension plans (except at termination). Actuaries help calculate.|
|Other notes||My wife has this plan.||I have this plan 🙂|
What happens when you leave the organization and you have a pension?
When leaving your employer, if you have a DC plan, things are rather straightforward.
If you own a DC plan, the full market value of that plan at the time of your leave can be transferred to a personal Locked-In Retirement Account (LIRA).
I won’t go into too many details on LIRAs since as you guessed it, I also have other blogposts about that subject including how I manage my LIRA. (I used to have a DC plan when I worked and lived in Toronto. I moved my DC plan money into a LIRA when I left my former employer. I’ve had this LIRA ever since.)
With a DB plan, it’s a bit more complex to say the least. Which brings us to our reader case study for today and my thoughts and comments on that.
Reader Case Study (questions and information adapted slightly for the site):
I really enjoy your blog!
I also really like your concept of hourly passive income wage – it’s something I’m now tracking myself!
Thoughts on this for us although I know you can’t offer specific advice but your perspectives would be good given I have read you have a pension as well.
- I have been managing my investments for a few years now and have recently been more focused on financial independence topics as my wife and I have a goal of her stopping full time work this year to focus on family (3 young kids at home) and our health.
- We are in Ontario. We are very fortunate as we are both in the healthcare field with HOOPP defined benefit pension plans. If we both were to continue to work until 55 and take our DB pensions we’d be essentially ‘set for life’. We are lucky and grateful.
- That said, we are seriously contemplating having my wife retire from her full time job (now) to focus on our young family and her health (both are more important). We are electing to take the commuted value of her pension. She is 45.
- If we were to go this route, we would then plan to take my pension as a monthly amount regardless of when I retire or leave employment with my healthcare role. I enjoy my role and have no plans of retiring. Maybe in another 14 years, so a pension around age 55.
My thinking is – if our investments earn at least 5% on average going forward we could be well ahead of what the future monthly pension amount would be.
So, your thoughts?
I feel we could have the best of both worlds this way (I could keep working; contribute to my pension; my job is very stable) AND we could have the lump sum commuted value for us to invest as my wife stays home and supports our family.
Yes, we would take a VERY large tax hit in the year the lump sum is paid out (ouch!) but for the first year of my wife’s retirement she is planning to focus on health and family.
We plan to live off my salary alone and while our savings rate would be very close to 0%, we could do it. We have been consistently living off my income alone for around 18 months now and saving the rest so we know this is very feasible (on one salary).
Worse case, if things do not work out, my wife can easily go back to a part time or full time job to supplement our lifestyle and long-term savings.
Thanks so much for any thoughts!
Lots to unpack, so let’s get into it.
Similar to what I wrote back to this reader, I believe there are a number of considerations. Let’s go through those one by one but before that, let’s show some math.
- Consider the maximum transfer value for your tax hit. For any commuted value (i.e., the lump sum amount to be paid out), the maximum transfer value (MTV) is something to be mindful of. There is legislation (a regulation in the Income Tax Act) that regulates that. My understanding is (since I haven’t been in this situation yet myself!), there is a maximum transfer value/present value factor (the amount you can move into a Locked-In Retirement Account (LIRA)) that will prohibit you from transferring the full value of your pension into any LIRA unlike any DC plan.
Here is the current MTV table as I understand it based on the current Act up to age *71:
*We could go beyond age 71 but for the purposes of this post it’s not relevant, the present value factor continues on a downward trend.
|Under age 50 = 9||57 = 10.8||65 = 12.4|
|50 = 9.4||58 = 11||66 = 12|
|51 = 9.6||59 = 11.3||67 = 11.7|
|52 = 9.8||60 = 11.5||68 = 11.3|
|53 = 10||61 = 11.7||69 = 11|
|54 = 10.2||62 = 12||70 = 10.6|
|55 = 10.4||63 = 12.2||71 = 10.3|
|56 = 10.6||64 = 12.4||*And on and on…|
Table source – Advisor.ca
To use the table for MTV, select your age at retirement.
For example, for our reader, age 45, they would have a factor of 9.
**In our simplified example, take your factor and multiply that by your annual pension income expected at age 65. (I’m making this annual pension number up but let’s assume the annual benefit at age 65 is $30,000 for our case study. With HOOPP it could be higher.) **Calculations for months between years are a bit tricky.
So, at age 45, the formula is:
MTV = present value factor X annual benefit.
MTV = 9 (under age 50) X $30,000 = $270,000.
As long as our reader’s commuted value is less than $270,000, they can put that entire amount into a LIRA.
Otherwise, this comes into play:
1b. Given the maximum direct transfer value into the LIRA, if the commuted value is higher, then you may be able to put some of your commuted pension into your RRSP – if your wife in this example has available RRSP contribution room. That may or may not be available because many folks such as your wife who own a healthy /generous DB pension don’t often have any pension room because the pension contributions themselves limit RRSP contribution room – thanks to a pension adjustment. A good problem to have of course but a major downside when you commute. That brings me to my final point on MTV below.
1c. Given only so much money can go into a LIRA, to be tax-sheltered, and then only so much can go into your RRSP based on any available RRSP room (that may not exist) then you might get taxed (heavily) since the rest is a lump sum taxable amount.
Example for our reader assuming she has no RRSP contribution room:
- Commuted value statement of DB pension at age 45 is actually worth $400,000. Nice! But wait!
- Only $270,000 can be put into LIRA.
- No RRSP contribution room.
$130,000 is paid out as a lump sum and is taxable.
Assuming a 40% tax rate (example only), then $52,000 lost to taxation for an after-tax balance of $78,000.
So what Mark? We still want the money!!
I get it.
In this hypothetical example, a $400,000 lump sum payout is absolutely a pile of money and I can appreciate that. Yet, before your wife rushes into signing any paperwork and taking the cash, consider these other items beyond MTV even though the money seems great.
- Can you invest wisely?
Beyond the tax considerations for any lump sum payment, I would make sure your wife will reasonably invest as well as the pension plan itself. This often means earning about, as you point out, 5-6% long-term annualized rate of returns that most balanced portfolios, like pensions are, should return.
To earn more than 5-6%, my personal experience has been you should have a bias to owning more equities than bonds in your portfolio. You should also strive to invest in a way that delivers market-like returns with time.
Can you stomach equity risk? Can you stay the course when the market sky is falling? Easy to say, very hard to do. I will leave that decision to your wife and yourself to discuss!
Bottom line on this point: what you must consider is taking any lump sum/early retirement package from the company, and your ability to duplicate the same eventual income by commuting it. Depending on your age, time vested in the plan, a deferred pension payable from the plan could be worth it for the dependable payments it will provide. This is very much a risk-based and risk-tolerance decision. One you cannot change your mind on.
My take: The short/shorter timeframe you’re vested in a DB plan, I think it makes far more sense to commute. The longer timeframe you’re in a DB plan, or certainly if you’re near retirement age after decades of years of service, I would at least consider leaving your money in the plan. Talk to a licensed professional. More on that in a bit.
- Is your DB plan indexed?
Some pensions have some inflation protection built-in, in line with Consumer Price Index (CPI) increases. Building in inflation protection into your personal portfolio might not be as easy. I would enquire about that before your wife makes a decision. HOOPP may or may not be indexed.
My take: If indexing is part of your plan, you might want to keep money in the plan. Why? Inflation should be expected over time, how much, we don’t really know. My plan has something like this: indexing is effective January 1st following retirement and payments will be indexed based on 75% of the Consumer Price Index to a maximum of 5.5%.
- Gosh forbid, but what about shortened life expectancy?
If either of you have a health issue, it may make sense to commute the pension and leave a lump sum to your partner. I would however check your wife’s survivor benefits package in this case study since survivor benefits with HOOPP could be 66.6%, 80% or higher.
My take: My DB plan offers 66.6% survivor benefits. That’s pretty good. Should something happen to me, my wife gets my pension at that benefit rate PLUS my benefits are guaranteed for a period of time. Read on:
“Under the normal form of pension payment, your retirement income is payable for your lifetime with a guaranteed minimum of 120 payments. In the event of your death before you have received 120 monthly pension payments, the balance of these 120 monthly payments will be paid to your beneficiary. However, if you have a spouse when you retire, your monthly pension will be automatically reduced so that your spouse will receive 66 2/3% of your monthly pension after your death, which is the 66 2/3% joint and survivor form of pension payment.”
Again, the longer you are in such plans, the more valuable these benefits become. Don’t rule out the benefits from the benefits!
- Is your company stable?
When it comes to HOOPP, heck ya. A quick Google search and folks can read up on that but our reader already knows that. For others, any defined benefit pension is only as good the company supporting it. Think Sears Canada, Nortel and the list goes on!
My take: My DB plan is affiliated with many collective healthcare agreements across Canada, so I’m personally not concerned my pension will end up like Sears Canada or Nortel.
- Want to pension split?
With a pension, again, not there yet myself, you can split pension income as soon as the pension starts. With a LIF (income drawn from LIRA) your wife will have to wait until age 65 before she can split pension income. (See provincial and federal regulations for details). Something to think about when you want to optimize your taxes! The pension income tax credit can be appealing.
My take: For our reader, if you intend to work until age 55 or so, maybe this doesn’t make as much sense. Typically, if you are the recipient of the pension and are 65 or older, you may split income from your RRSP, RRIF, life annuity, and other qualifying payments. If you are under 65, it depends, only certain payments are eligible for pension splitting. With many years vested in your DB plan, with a sizeable commuted LIRA from your wife’s plan, maybe you’ll have plenty of flexibility anyhow.
- Unlock and unleash the LIRA!
Some provinces allow you to unlock some of your LIRA – say 50% (and put assets into RRSP for example), yet other provinces beyond that allow you to unlock it all before it becomes a LIF or annuity! (I recall Saskatchewan is like this). Pension legislation is messy across the country. Best to confirm with your plan provider in all cases what the unlocking rules are in advance.
My take: Since I live in Ontario and I’ve read up (a bit) on this stuff myself, for pensions in Ontario you should be able to transfer out 50% of the pension funds into a RRSP or RRIF at a certain age. That provides great financial flexibility and a positive side to commuting! Always double-check the unlocking rules with the provincial regulator. In Ontario click here.
- If you do commute, do it January 1st when you haven’t earned any income.
One “trick” I’ve heard of (and I certainly haven’t done this myself…) is if you’re going to “retire” or leave your employer voluntarily, then do it early in the calendar year when you’ve earned next to nothing for taxation purposes – and commute your pension at this time.
My take: I’ve talked to a few early retirees and they’ve done this. They have retired in the months of January, February and into early March for that very purpose and tactic – since any monies paid out in a lump sum that cannot be moved into a LIRA, or as part of your RRSP contribution room, are paid out in a taxable sum.
Closing thoughts – should you take the commuted value of your pension?
Hard for me to say for you at age 45!
Kidding aside, I see the real benefit of commuting your pension before your 50s as one that offers flexibility – assuming you haven’t been in the DB plan very long AND you can invest wisely AND you can keep your ongoing your money management costs low. With this decision, just be mindful you’re now taking on all the investment risk.
I see the real benefit of staying in your DB plan, say after age 50, for the fixed income security it will provide – assuming you’ve been in the plan for maybe 20 or closer to 30 years. With this decision, the employer keeps the investment risk. Maybe you have enough investment risk with your own assets. You can sprinkle that steady pension paycheque in with income derived from your personal portfolio.
Even with a company pension plan (DC or DB), I think it’s very wise for Canadians to contribute to at least their Tax-Free Savings Account (TFSA) – and max that account out every year. That’s because the income and returns earned inside the TFSA are not income tested. There will be no reduction in the means-tested government benefits like Guarantee Income Supplement (GIS) and/or Old Age Security (OAS) regardless of how much you have sheltered or will withdraw from the TFSA in the future (based on current TFSA rules of course)! This makes the TFSA an outstanding account to own – for any pension backup.
Also, while a portion of the pension lump sum payment may be taxable, the money leftover can go to your mortgage payment or building your emergency fund (if not already done). Both GREAT things!
Lastly, and I can’t stress this enough, these are my perspectives only. Whenever in doubt speak to a fee-only planner or tax accountant professional that can help you make this major (and irrevocable) financial decision. I can only speak to my insights, what I’ve learned and how I intend to keep my DB pension with my current employer for the future fixed-income payments they will provide. I might commute my pension eventually as well.
Disclosure – My Own Advisor is not a tax expert, this is not tax advice nor any form of financial advice. I strongly advocate any reader consider working with a fee-only planner or tax professional to ensure they are getting the best advice for the best personal reasons for their own unique situations. Misinformed commuted pensions decisions could cost you your retirement. Ensure any planner or professional you work with has a designation and no conflicts of interest. Thanks for reading.