The Pros and Cons of Commuting a Pension
In years gone by, many people sought a job that would provide the proverbial “gold-plated” pension plan, by which was meant a defined benefit pension, what one might refer to as a “true” pension. That is, once you retired, you would get guaranteed, possibly inflation-protected, monthly payments for the remainder of your life and, if you left a surviving spouse, the survivor would continue to receive a portion – typically 60 percent – of that pension for the rest of his or her life.
The defined benefit pension plan has unfortunately become increasingly rare. If you work in the public sector such as government, education, or health care, or for major for-profit businesses, such as banks, construction companies, or utilities, you may have a defined benefit plan awaiting you at retirement. However, for many others, if you do contribute to a registered pension plan, it is more likely a defined contribution plan, which offers none of the guarantees of a defined benefit plan. The difference between the two is apparent in the name. The first type defines the benefit you will receive at retirement, whereas the terms of the second type of plan only define the amounts that are contributed by you and your employer. What you actually have available to fund your retirement is entirely dependent on the performance of the investments – that you were responsible to decide on – in the plan.
Despite the high esteem in which defined benefit plans are often held, some prefer to commute their pensions, meaning that instead of accepting the terms of the pension, they would rather take a lump sum and embrace some uncertainty in exchange for the potential for a higher income in retirement and the possibility of passing on the accumulated pension assets to their heirs.
What Does it Mean to Commute Your Pension?
Commuting your pension is the process of converting the lifetime benefit of your pension into cash that will go to you now. To say that the money goes to you now does not mean that it’s all yours to immediately spend as you like. Rather, the commuted value, up to the “Maximum Transfer Value” (MTV), which is set according to the Income Tax Act, would be transferred to a Locked-In Retirement Account (LIRA). It is often the case that the commuted value is greater than the MTV, in which case the balance is paid out to you as taxable cash unless you have contribution room in your RRSP. In that case, you can offset the tax liability by the amount you contribute.
The Pros of Commuting Your Defined Benefit Pension Plan
Why would someone want to commute their pension? There are several possible reasons.
The money is more accessible to you under the rules for LIRAs, including unlocking provisions.
If you leave a job, you may wish to take the value of your pension plan with you so that you are no longer tied to your former employer. In that case, you would transfer the portion of your pension that does not exceed the MTV into a LIRA. Depending on the jurisdiction of your pension plan, once you reach a certain age, 55 in Ontario, for example, you can unlock up to half of the LIRA’s value and move it into a Registered Retirement Savings Plan (RRSP) if you are young enough, or a Registered Retirement Income Fund (RRIF). The balance goes into a Life Income Fund (LIF). While RRSPs/RRIFs have no limits on how much can be withdrawn, RRIFs have annual minimum payments that must be taken. LIFs, on the other hand, have both minimums and maximum amounts as they come from pension plans and are meant to last a lifetime.
If you want the flexibility to have more of your money available to you than you can receive through your monthly pension, then taking advantage of this unlocking provision by commuting your pension can be effective.
You can manage and invest the money directly, potentially for a higher return.
Pension plan members generally have little to no say in how their defined benefit pension plan is invested. Occasionally, members can push plan administrators to pursue a particular socially responsible investment agenda, divesting from fossil-fuel industries or investments domiciled in Russia, for example, but they usually do not have an opportunity to get more specific than broad investment policy. If you commute your pension, you get to manage your investments directly, potentially for much greater returns.
You have a range of income-paying options once you convert your LIRA to a LIF.
You cannot contribute to your LIRA, but you have a wide range of options available to you in terms of investments. The same applies to a LIF, the withdrawal phase for your retirement assets. You can be aggressive, 100% in equities, or very conservative, 100% in Guaranteed Investment Certificates (GICs), or anywhere in between. In a RRIF, you must take out a minimum amount based on your age and the value of your account as of January 1 each year. There is no maximum. In a LIF, you can take out anything from the minimum to the maximum. The maximum is the greater of your investment returns from the previous year or a factor that is defined by the legislation that is governing your plan.
In contrast, with your pension, you get your regular pension amount month after month, perhaps adjusted for inflation, which may or may not suit your income needs.
If you die early in retirement, the remaining balance of the account can be left to your beneficiaries.
With a pension plan, you typically have several options available to you in terms of the payout. If you are married the typical or default option is that, following your death, your surviving spouse can continue to receive 60% of the amount you were receiving. If you wish to receive less but provide relatively more for your spouse, you can choose for your spouse to receive up to 100% of the amount you are receiving. However, the amount you receive will be reduced.
Once your spouse dies, though, the pension is usually gone; nothing is left to your heirs. If you commute your pension, however, the balance you leave behind after your death can be rolled over to your surviving spouse tax-free. And, if there are still funds left after the death of the survivor, the balance remaining can go to your heirs. Taxes will be applicable, however, as there is no tax deferral available to a beneficiary who is not a spouse unless the beneficiary was a dependent child or grandchild. Nevertheless, the capacity to provide the balance to the next generation certainly has its appeal over the complete loss of the pension once the surviving spouse dies.
You avoid the risk of the pension plan becoming insolvent.
If you are concerned about the long-term viability of your employer and your employer-sponsored pension plan, you may think it best to get your money out while you can. Nortel and Sears Canada pensioners are two groups of people who probably wished they had taken the commuted value of their plans when they had the chance. When companies go under and leave their pension plans underfunded, it is the pensioners who are left in the lurch. One lesson here is to read your annual pension report and if you see that your company is chronically falling short of its obligations, commuting may be a viable alternative.
The Cons of Commuting Your Defined Benefit Pension Plan
You are responsible to make the investment decisions by yourself or with the assistance of an advisor.
While most of my clients like to invest for themselves, not everyone has the desire or capacity to become a Do-It-Yourself (DIY) investor. With a pension plan, you put in your portion, if there is any – some employers fully fund defined benefit plans – and the plan administrator takes care of all the rest. When your pension gets commuted into a LIRA, then you have to make the investment decisions. Now, those decisions can be delegated; not everyone needs to be a DIYer. When you consider that you might suddenly be responsible for a half-million-dollar account, that can be pretty daunting, so the idea of using an advisor, whether full-service or the “Robo” version, makes all kinds of sense. Nevertheless, you are now the party responsible for making those arrangements.
The amount of your commuted value that is above the MTV can be more than half of the value of the plan; you might pay a significant tax bill.
Indeed, in an illustration from 2017, a person who chose to commute her pension had a total commuted value of $1,559,000 but an MTV of only $574,000. That leaves $985,000 that is subject to income tax, less any room that she has to contribute to an RRSP. Assuming there is no room, and ignoring any other taxable income, depending on the provincial income tax applicable the average tax rate could go as high as 50.6% or as low as 44.4%. In dollar terms, that ranges from a high of $498,565 to a low of $437,688 given over to taxes.
Poor planning combined with the ability to unlock a sizable portion of the plan could lead to you falling short of your needs later in retirement.
The commuted value of your pension is still intended to be used to support you in retirement. If you have a significant amount of your pension that is taxable there is no obligation to use the after-tax balance for retirement savings. Instead, you may wish to renovate your house, upgrade your annual vacations, and/or help your children out with down payments on their first homes.
Depending on the jurisdiction of your plan, you may be able to unlock part of your plan – for example, Ontario allows 50% unlocking – and transfer that unlocked part to a regular RRIF rather than a LIF, which has a maximum limit. If you continually withdraw larger amounts, because you can, you may find yourself with inadequate resources later in retirement. Given the large tax hit, the non-registered nature of the amount above the MTV, and the ability to unlock a part of your pension, a lot more discipline and planning are necessary than would be the case if you left the funds in the plan.
Poor investment returns could limit the amount of retirement income you can generate.
While many assume that they can grow their retirement assets to such an extent that the income generated will be better than what they will receive from their pension, that is not always the case. Furthermore, when the benefit is defined, the onus is on your employer to arrange to pick up the slack and increase the funding. When you take over the money, it’s all on you.
Unlike some pension plans, commuted assets do not have inflation-protection guarantees.
Some pension plans provide full inflation protection; others will provide variable protection, depending on the performance of the portfolio the pension plan invests in, while others still, most commonly in the private sector, do not provide inflation protection at all. There is no built-in inflation protection for your LIRA or LIF. Yes, over the long run, investments in equities have historically generated returns above inflation, but there is no contract written into your investment that says your account will do that for you.
Additional benefits available to those in the pension plan, such as extended health care, are often lost when the pension is commuted.
Finally, I want to bring into consideration the potential loss of benefits. Some employers offer extended health care benefits, effectively extending your group plans into retirement. However, if you commute your pension, typically you have also taken yourself entirely out of your employer’s pension administration system and therefore have cut yourself off from eligibility for these extra benefits.
An Alternative to Commuting: The “Copycat” Annuity
Technically, the “copycat” annuity is still a type of commutation, but it effectively gives you your pension plan without subjecting you to the uncertainties brought on by poor management by your employer.
The term “copycat” refers to the necessity of taking the entire commuted value to an insurance company and buying an annuity contract that will give you “materially” the same rights that you would enjoy under the pension plan.
Why would you want to do this? Well, if you are like many retirees, you want steady reliable income. If you fear that the pension from your employer is in jeopardy, you might want to commute your pension and buy yourself a new pension with the same terms but under the management of a rock-solid insurance company. Life insurance companies are members of Assuris, an organization that protects policyholders against the insolvency of the companies where they hold their policies so there are some assurances in the case of an annuity that there are lacking with a company pension plan.
What should you do?
It’s not really for me to say whether you should commute your pension, at least not before developing a financial plan to put that decision in its proper context. For some people, it makes sense, for others not so much. At a very personal level, I like the idea of having some portion of my income in retirement being paid out on a regular and reliable basis. That reliability also reassures me that I can take reasonable degrees of risk in the non-guaranteed parts of my investment portfolio, without worrying obsessively about catastrophic loss. No doubt you will have your own reasons. Read your pension documents and talk to your pension plan administrator if you have questions. Or, if you wish, reach out to me or another qualified advice-only financial planner to have someone work on it with you together.
This is the 137th blog post for Russ Writes, first published on 2022-02-28.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.