Take the Commuted Value of Your Pension, or Leave It in Place?

The stakes for this decision can be high, as your choice is irreversible, the value of your pension can be significant, and you may not have much time to decide. How do you make a decision you feel confident about? Here’s an overview of the choices you might be facing, along with the pros and cons to consider for each option.

Option 1: Leaving the pension in place

Although you won’t be working at your job any more, one option that’s usually offered is leaving the funds that have accumulated in your pension plan in place. Then, when you are eligible – based on your age and the rules of that plan – you would receive a monthly income. For example, you might be eligible to start receiving income at age 55, 60, or 65.

If this option is available, when you leave your job you will be provided with information about when your income from the pension plan would start paying out, how much the monthly income would be, and the assumptions that have been used to determine how much you’d receive.

Option 2: Commuting the pension

A second option is to “commute” your pension entitlement by taking the funds out of the pension plan. This option is typically called commuting your pension to cash, or “cashing out” your pension benefit.

With this option, the funds in the pension plan would be transferred to a Locked-In Retirement Account (LIRA), up to something called the Maximum Transfer Value, a limit set by the Income Tax Act. Any amount that’s greater than the Maximum Transfer Value would be paid out to you as taxable cash. You could then contribute some or all of these funds to a Registered Retirement Savings Account, if you have contribution room. (If you don’t have RRSP room, the full value of the cash portion of your pension benefit will be added to your taxable income for that year.)

A second option for commuting your pension, depending on your pension plan, might be to use the funds set aside for you to purchase a life annuity from a life insurance company. The annuity would need to match the benefits you’d have under the plan.

The Canada Revenue Agency will allow all of the funds in your pension entitlement to be transferred over to a life insurance company to purchase an annuity without any tax consequences, so long as the annuity is identical or very close to the pension benefit you would have received, if you stayed in the plan. That’s why this kind of annuity is called a “copycat annuity.”

Option 3: Transfer your entitlement to a different defined-benefit pension plan

Finally, if you’re moving from a job with a defined-benefit pension to a different job with a defined-benefit pension, you may be able to transfer the funds you’ve built up in the pension plan from the first job to the plan at the new job. This option will depend on the details of each pension plan.

Which of these options might be right for you? There are pros and cons for each.

Option 1: Leaving your pension in place – Pros and cons

Pros:

• If you have a spouse or common-law partner, the pension can continue to pay them (usually at a reduced rate, such as 60 per cent of your pension payment) after you pass away.

• You don’t have to take any investment risk or make any investment decisions – those risks and decisions are all in the hands of the pension plan, not you.

• Your pension will start as promised, and pay out as promised, even if investment markets dip before or during your retirement.

• The monthly income from your pension is eligible for “pension income splitting,” which can reduce your household tax bill if you have a spouse or common-law partner.

Cons:

• The money in the plan is not liquid, but is paid out from month to month.

• If the pension plan “runs into trouble,” your pension benefit might be at risk.

• The pension income dies with you, or your spouse, if you have one – there is usually no estate value left after the second spouse passes away. If you don’t have a spouse or common-law partner, the income from your pension plan ends when you pass away.

Option 2: Commuting your pension – Pros and cons

Pros:

• If you commute your pension to cash, the money in your plan is accessible to you and, subject to tax rules that govern how the funds in a locked-in retirement account can be “unlocked,” can be spent to meet goals other than providing retirement income.

• You can manage the funds in your locked-in account directly, taking more or less investment risk as you choose.

• If you pass away earlier in retirement, the remaining value in your account can be left to your beneficiaries.

• If you commute your pension to a “copycat annuity,” you can avoid any risk of the pension plan becoming insolvent, and failing to make the promised payments. The income from a copycat annuity is also eligible for pension income splitting, and is protected from default through Assuris, the not-for-profit organization that protects Canadian policyholders if their life insurance company fails.

Cons:

• If you’re not comfortable making investment decisions, you may have concerns about making all of the investment decisions for your locked-in retirement account yourself.

• The amount of your commuted value that is above the Maximum Transfer Value can be high – as much as 50 per cent of the plan value, or more — meaning that you might face a significant tax bill if you commute to cash.

• Without a financial plan in place, you may be tempted to deplete the funds that had been set aside for retirement on other, shorter-term goals — meaning you might fall short once you hit or when you’re in retirement.

• Market downturns just before or early in retirement, when withdrawals start, can limit the amount of retirement income your commuted value can produce.

• Usually, the amounts you invest on your own don’t have the same guarantees as the payments from a pension plan. For example, funds you invest on your own aren’t guaranteed to provide income for as long as you’re alive, usually don’t offer any guaranteed inflation protection, and aren’t guaranteed to pay out the same amount even if markets drop.

• If you commute your pension plan to cash, the income you receive from the commuted amounts is not eligible for pension income splitting.

• If you commute your pension plan to a copycat annuity, the income is not liquid and, like payments from your pension plan, the annuity income dies with you, or your spouse, if you have one – there is usually no estate value left after the second spouse passes away. If you don’t have a spouse or common-law partner, the income from your annuity ends when you pass away.

As you can see, there are pros and cons for each option you might be considering. If you’re facing this decision, how will you know which option is right for you? Here are a few points to consider.

First, any decision you make – whether staying in the plan, commuting to cash or a copycat annuity, or transferring your pension benefit to a new pension plan – should be made in the context of your overall goals. If you don’t have a clear picture of what you want your financial future to look like, this could be an opportunity to create one.

Of course, you’ll also want to review the details of your specific options carefully, to make sure you’ve thought through all of the choices available to you. You’ll also want to assess the overall health of your employer pension plan, to evaluate whether you expect it will be able to pay out the promised benefit when the time comes.

All in all, if you’re facing a decision about remaining in or leaving your defined-benefit pension plan, it might make sense to get some personalized financial advice from a pro who is suited to provide the advice you need.

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