A client’s age, risk tolerance, investment knowledge, and estate planning goals should all be considered when deciding whether to commute a pension.Dragon Claws/iStockPhoto / Getty Images
This article is part of a new Globe Advisor series, Pensions Unpacked, exploring how workplace pensions fit into retirement strategies, and the technical details and decisions that come with the plans.
Deciding whether to commute a pension plan or keep it with a former employer can be challenging and emotional for clients when leaving or being let go from a firm.
Factors include a client’s age and longevity expectations, risk tolerance and investment knowledge, retirement and estate planning goals, and the long-term stability of their pension plan provider.
The stakes are high because the decision to commute is irreversible and pension plan values can be significant, says Samantha Sykes, senior investment advisor with Sykes Wealth Management at Raymond James Ltd. in Toronto. “It’s always a big chunk of money.”
Advisors will want to determine what kind of pension plan their clients have: a defined-contribution (DC) plan, in which the employee assumes the investment risk, or a defined-benefit (DB) plan, in which the employer does.
(With a group RRSP, which is not a registered pension plan, a client can transfer the plan to a personal RRSP, purchase an annuity or withdraw the cash on a taxable basis.)
The DC decision
When leaving a firm with a DC plan, clients can decide between keeping the plan with their former employer, transferring it to a new employer’s plan (if possible), purchasing an annuity, or transferring the accumulated value to a locked-in retirement account (LIRA), to be managed personally or with the help of an advisor.
Some clients, particularly younger ones comfortable with investing on their own, may prefer to transfer their DC plan to a LIRA to have access to a broader range of investment options relative to the limited selection of funds some employer plans offer, says Anna Golan-Resnick, certified financial planner with Objective Financial Partners Inc. in London, Ont.
For those clients, the returns from DC plans may not be very appealing, she says, and they may decide they can do better.
Transferring funds to a LIRA – which is then ultimately converted into a life income fund to provide an income stream – may provide clients more flexibility in terms of unlocking and withdrawing funds (to the extent permitted under relevant provincial legislation) compared with leaving a pension with an employer.
However, older clients closer to retirement or those who are more risk-averse may prefer the security of a pension.
“It’s very appealing just to know they will have [monthly] income for the rest of their lives,” Ms. Golan-Resnick says.
Pension payments from a DC plan are generally known as variable benefits as members can direct how much income is paid out annually, subject to a minimum and maximum amount. (Not every province allows for variable benefits from a DC plan.)
Commuting a DB plan
The decision of whether to commute a DB pension plan can be more complex, but in most cases, clients are better off remaining in the plan. Some plans don’t allow members to commute their pensions.
Clients leaving an employer are typically offered a lump sum present value of the future monthly income payments they would receive if they remained in the DB plan. The value is based on factors such as age, average salary, years of service and interest rates. (Plan members older than a threshold age set by the plan – often, 55 – may no longer be able to commute their pension.)
Clients have a set period to choose to commute the pension at the lump sum amount; otherwise, they remain in the plan. After the window closes, they may have the option of asking for the plan to calculate a new lump sum commuted value, which could be a higher or lower amount than they were offered previously.
Clients can transfer the commuted value to a LIRA, but only up to a maximum transfer amount calculated under rules set out in the Income Tax Act. They will receive the difference as a taxable amount. If the client has RRSP contribution room available, they may contribute all or part of the difference in order to mitigate the tax hit.
Most DB plans will permit the member to transfer the commuted value to another pension plan, provided that plan will accept the amount, says Lea Koiv, president of Lea Koiv and Associates Inc., a retirement and tax planning firm in Toronto. In some cases, the plan will permit the member to acquire a copycat annuity, which is an annuity that mimics the rights under the pension plan.
Ms. Sykes says she reviews a client’s DB plan to see whether it’s well funded and to determine what features and options it offers. For example, does it offer spousal benefits, bridge benefits and continued access to employer-provided health benefits, and is it indexed to inflation? The better the benefits, she says, the more incentive for clients to stay in the plan.
“It takes a lot for me to recommend that somebody pull out of their DB pension,” Ms. Sykes says.
Doug Carroll, tax and estate specialist at Aviso Wealth in Toronto, says clients with a shorter life expectancy – particularly those without a spouse – and those interested in leaving a legacy to beneficiaries may consider commuting a DB plan.
Clients concerned that their pension plan is not adequately funded or who believe their former employer may run into financial difficulty could also opt to take the commuted value rather than to stay with the plan, Mr. Carroll says.
However, most clients are likely better off staying in a stable DB plan, particularly if it’s a government plan offering indexed pension payments, he says.
Editor’s note: This article was updated to clarify that someone with a DB pension plan may have continued access to employer-provided health benefits. The pension plan itself does not offer health benefits.