When it comes time to retire or leave a job, you’re often faced with a critical decision: should you take the commuted value of your pension or stick with the monthly payments? This decision can significantly impact your long-term financial security. Let’s break down what a pension plan is, what the commuted value entails, and when taking it might—or might not—be the right move for you.
What is a Pension Plan?
A pension plan is a retirement savings vehicle offered by employers to provide income to employees once they retire. It’s a way for employees to build retirement savings without needing to invest heavily in personal retirement plans. Think about it. The Canada Pension Plan, CPP, is the same. You contribute, plus your employer contributes. Contributions and years of contributing provide the pension. I recently saw a CPP cheque for $1,825 taken by a person at age 70.
There are two main types of pension plans:
- Defined-Benefit Pension Plan: In this type of plan, your monthly retirement income is predetermined based on factors such as your salary and the number of years you worked. The employer is responsible for ensuring there’s enough money in the plan to meet its obligations, and your income in retirement is guaranteed.
- Defined-Contribution Plan: With this plan, both you and your employer make contributions to your pension, and the amount you receive in retirement depends on the performance of the investments made with those contributions. There’s no guaranteed retirement income, and you bear the investment risk.
When you leave a job with a defined-benefit pension plan, you often face a choice between receiving a monthly income for life or taking the commuted value of your pension as a lump sum.
What is the Commuted Value of a Pension?
The commuted value represents the lump sum equivalent of the future monthly pension payments you would have received. In simpler terms, it’s the amount of money you’d need today to fund the pension payments you’d be entitled to over your lifetime.
The calculation of the commuted value is complex and depends on factors like:
- Your age
- Current interest rates
- Your life expectancy
If you decide to take the commuted value, you’ll receive a one-time payment instead of the guaranteed monthly pension income. You can invest this money yourself in a locked-in retirement account (LIRA) or another savings vehicle.
But taking the commuted value comes with risks. Once you have the money, you’re responsible for managing it, and there’s no guarantee that it will last as long as you need it to. If your investments don’t perform well, you could run out of money before the end of your retirement. Make your money work for you: talk with us.
Book A Pension Consultation Call - Don't Delay!
Click the button below to book a consultation call with a Certified Financial Planner. With more than 25 years of experience, our approach is clear and practical. We help simplify pension, investment, retirement, estate, and tax planning so you can focus on what matters most. We've had the privilege of advising retirees and employees from organizations such as Ontario Teachers, Stelco, UPS, ArcelorMittal Dofasco, GM, and many others. Book a free 15-minute consultation call today.
Why Would You Consider Taking the Commuted Value?
There are several reasons why you might consider taking the commuted value of your pension rather than leaving it in the plan.
Flexibility and Control
By taking the commuted value, you gain full control over how the money is invested. You can choose to invest in a variety of assets—stocks, bonds, real estate—that may offer higher returns than a traditional pension plan. This flexibility can be appealing to those who feel comfortable managing their finances or working with a financial advisor.
Inheritance and Estate Planning
When you take the commuted value, any money that’s left when you pass away can be passed on to your heirs. With a defined-benefit pension plan, however, the payments typically stop when you and your spouse pass away. If leaving a legacy is important to you, commuting your pension gives you more options for ensuring your loved ones benefit from the remaining funds.
Lump Sum Investment Potential
Taking the commuted value offers the potential for higher investment returns. If you invest wisely and the market performs well, your lump sum could grow significantly, providing more retirement income than the pension plan would have.
Health Considerations
If you’re in poor health or expect a shorter retirement, taking the commuted value might make more sense. You can use the money now for medical expenses or other needs, and you won’t be relying on monthly pension payments for an extended period. Let’s do the math. If your pension is calculated to pay a retiree for 30 years but you only live 20, then you lose. The other 10 years of money goes back to the plan.
Why You Might Want to Stick With the Pension Plan
While there are advantages to taking the commuted value, there are also compelling reasons to leave your pension in place and receive a guaranteed monthly income for life.
Guaranteed Income for Life
The most significant advantage of a defined-benefit pension plan is the guarantee of lifelong income. Once you start receiving pension payments, you know exactly how much money you’ll get each month, and you don’t need to worry about market fluctuations or poor investment performance. For many retirees, the peace of mind that comes with a guaranteed monthly pension is worth more than the potential gains from taking the lump sum.
No Investment Risk
With a pension, you don’t have to worry about how your investments are performing or whether your money will run out. The pension plan takes care of everything, and you receive regular payments without the risk of losing your capital.
Protection Against Longevity Risk
One of the greatest financial risks in retirement is outliving your savings, also known as longevity risk. A pension plan protects you from this risk by ensuring that you receive a regular income for life, no matter how long you live. If you take the commuted value, you’re responsible for making sure the money lasts, and there’s no guarantee that it will.
Survivor Benefits
Most pension plans include survivor benefits, meaning that your spouse or partner will continue to receive a portion of your pension if you pass away. This can provide additional peace of mind for couples. While you can leave the commuted value to your heirs, managing a lump sum in the event of your death could be more complicated for your spouse.
What Are the Tax Implications of Taking the Commuted Value?
Taking the commuted value of your pension can trigger significant tax implications. The Canada Revenue Agency (CRA) places limits on how much of your commuted value can be transferred into a tax-sheltered account like a locked-in retirement account (LIRA) or registered retirement savings account (RRSP).
The maximum transfer value (MTV) is the portion of the commuted value that can be moved to a LIRA or RRSP without triggering taxes. If the commuted value exceeds this limit, the excess amount must be taken as a lump sum and is taxable in the year you receive it.
For example, if the commuted value of your pension is $400,000 and the maximum transfer value is $350,000, you would need to take $50,000 in cash, which would be subject to income tax. Depending on your tax bracket, this could result in a significant tax hit.
If you decide to take the commuted value, you’ll need to plan carefully to minimize the tax impact. One strategy is to contribute to an RRSP if you have unused contribution room. This can help offset the taxes on any lump sum you receive. Look at spouse’s RRSP room too.
How to Invest the Commuted Value of Your Pension
If you take the commuted value of your pension, the next step is to decide how to invest it. The most common option is to transfer the funds to a locked-in retirement account (LIRA), where they can grow tax-free until you retire.
Once you reach the minimum age for retirement, you can convert the LIRA into a life income fund (LIF) or a registered retirement income fund (RRIF), which will provide you with regular retirement income. But before you reach that stage, you’ll need to decide how to invest the funds within the LIRA.
Here are some investment strategies to consider:
- Diversify Your Portfolio: To spread out risk, consider investing in a mix of stocks, bonds, and other assets. This can help protect your money from market fluctuations while still allowing for growth.
- Consider a Balanced Approach: If you’re risk-averse, a balanced investment approach that includes both growth assets and income-generating assets might be the right choice. This can help protect your capital while providing steady returns.
- Work With a Financial Advisor: Managing a large sum of money can be overwhelming, especially if you’re unfamiliar with investing. A financial advisor can help you develop a strategy for growing your money while minimizing risk.
Is a Copycat Annuity a Good Option?
If you’re interested in taking the commuted value but still want the security of regular income, a copycat annuity might be the solution. A copycat annuity is designed to mimic the payments you would have received from your defined-benefit pension plan. It’s purchased from an insurance company and provides a steady stream of income for life.
One of the benefits of a copycat annuity is that it offers the same monthly income as your pension while removing the risk of leaving your money in an employer’s pension plan. This can be particularly important if you’re concerned about the financial health of your employer or the pension plan itself.
With a copycat annuity, you transfer the commuted value to an insurance company, which then guarantees the payments. This type of annuity is also protected by Assuris, a non-profit organization that safeguards policyholders if their insurance company fails.
What Are the Risks of Taking the Commuted Value?
While taking the commuted value offers flexibility, it also comes with risks. Here are a few to consider:
- Market Risk: If you invest the commuted value in the stock market, you’re exposed to market volatility. A market downturn could reduce the value of your investments, putting your retirement income at risk.
- Longevity Risk: There’s always the possibility that you’ll outlive your savings. If you take the commuted value and don’t manage the money carefully, you could run out of funds before the end of your retirement.
- Management Risk: Managing a large sum of money requires time, effort, and knowledge. If you’re not comfortable handling investments, you’ll need to hire a financial advisor, which comes with additional costs.
These risks are mitigated when you leave your pension in place or choose a copycat annuity, as both options provide guaranteed income for life.
When Does Taking the Commuted Value Make Sense?
Taking the commuted value can make sense in certain situations. Here are a few examples of when it might be the right choice:
- You Have a Shorter Life Expectancy: If you’re in poor health or don’t expect to live a long life, taking the commuted value allows you to use the money for immediate needs, rather than waiting for monthly payments.
- You Want to Leave an Inheritance: If leaving money to your heirs is a priority, commuting your pension gives you more control over how the funds are passed on.
- You Prefer More Investment Control: If you’re confident in your ability to manage investments and want the flexibility to grow your retirement savings, the commuted value offers that opportunity.
Taking the Commuted Value of Your Pension
Deciding whether to take the commuted value of your pension or stick with the monthly payments is a major financial decision that shouldn’t be taken lightly. Both options have their advantages and risks, and the right choice depends on your personal circumstances, health, and financial goals.
By carefully considering the pros and cons and working with a financial advisor if needed, you can make an informed decision.
