There are few personal finance decisions more difficult or complex than the choice between taking a deferred pension in retirement or a lump sum (commuted) value today. It’s a choice many Canadians face each year if they leave a job with a defined benefit pension plan. (If you have a defined contribution pension plan, there’s no “commuted value” and the decision whether to stay in or leave the plan is, as a result, much simpler.)
Deferring the pension may be the smarter choice for many pension plan members, but two powerful forces work against that decision. For one, our lizard brain prefers instant gratification and would rather have the money now to spend and invest as we please. The second force working against the deferred pension option may come from your financial advisor – particularly if he or she is compensated by a percentage of your investable assets.
To be fair, depending on your situation taking the commuted value may indeed be the right choice. Each pension decision is unique based on your individual circumstances and the details of your pension plan. That’s why it’s important to get unbiased advice and input into your situation to help you make the best decision.
Further complicating matters is that your pension plan provider typically requires you to make a decision within six months or so. Fail to send in the paperwork on time and the default decision will be to keep you in the pension plan. A timely decision needs to be made.
That’s where I find myself today as I review my termination papers from the Universities Academic Pension Plan (UAPP).
I left my job at the University of Lethbridge at the end of December with just over 10 years of pensionable service under my belt. My options include:
- Remain in the pension plan and take the deferred pension option, which would pay $1,241 per month beginning in June 2045 (age 65), and then a monthly amount for the rest of my life that’s pegged to increases in inflation over time.
- Take the transfer option of $290,143. The maximum prescribed transfer value (to a LIRA) is $134,028. The remainder would be paid in cash, subject to withholding taxes, and fully taxable as employment income in the year it is paid.
Deferring the Pension
“Pensionized” income, whether from a defined benefit plan, or from government benefits such as CPP and OAS, is extremely valuable. It protects against longevity risk – the risk of outliving your money – and gives retirees a stable floor of income that’s guaranteed for life, in addition to protecting against inflation risk and providing a “guaranteed” retirement (or retirement income) start date.
Plus, the more guaranteed income I have waiting for me in retirement, the more risk I can take with the rest of my portfolio (RRSP and TFSA), potentially keeping my 100 percent equity portfolio intact longer than I originally planned.
So why is this even a choice, given that this defined benefit pension offers some inflation protection (60 percent of the average increase in Alberta’s Consumer Price Index for the previous year), and would pay me nearly $15,000 per year starting at age 65?
To answer this question let’s look at the commuted value option, plus a couple of other factors that are giving me pause.
Taking the Commuted Value
When I last updated my net worth statement, I pegged the value my defined benefit pension plan at ~$224,000. Seeing the valuation north of $290,000 was a pleasant surprise (low interest rates drive up commuted values).
In fact, if I could simply transfer that entire amount to a LIRA then I would have already made up my mind and taken the commuted value.
Not so fast. What’s this maximum prescribed transfer value all about? You can read about it in detail here, but in a nutshell, it takes my age, annual pension benefit, and something called a present value factor to determine the maximum transfer value (MTV).
In my case the annual pension benefit is $14,892, and anyone under the age of 50 has a present value factor of 9.0. (The factors for other ages are set by Income Tax regulation, and are available in the article linked above.)
$14,892 x 9.0 = $134,028
The remaining $156,115 would be fully taxable and paid out in cash. Not ideal.
I would have the option to roll some of that amount into my RRSP. Unfortunately, I don’t have any unused RRSP contribution room.
Another factor to consider is that I quit my job in December and so I don’t actually have any employment income (salary) coming in this calendar year. My wife and I incorporated our online business several years ago and planned to pay ourselves dividends this year.
What that means is it wouldn’t necessarily be that punitive (tax-wise) for me to take a fully taxable cheque for $156,115 in 2020, compared to the tax I was expecting to pay anyways. If I opt for the commuted value, I just wouldn’t pay myself anything from the business this year, and perhaps even reduce the dividends we planned to stream to my wife this year.
That’s deferred income we can leave in the business where it’s taxed at a lower rate.
See why every pension decision is unique? Even though I’ve helped several clients wrestle with their own pension decisions, I decided to reach out to an expert to take a look at my options and give me some objective and unbiased advice.
Deferred Pension or Commuted Value?
Alexandra Macqueen is a certified financial planner, educator, and author. She’s kindly offered her expertise to look at my pension options. Here’s her response:
As a general rule, when advising someone about their pension options I focus on three big issues:
- The health of their pension plan,
- Their personal financial plans, and
- Understanding their options.
Let’s go through these one by one.
1) The health of your pension plan
In deciding whether or not to stay in your plan, the overall health of your pension plan should be one of your considerations – and it might even be the most important one.
What do I mean by the “health” of a pension plan? A “healthy” plan is one that is set up to meet its pension promises to you over the long term. Because your plan, if you stay in it, doesn’t start paying out to you for 25 years, you would have to feel confident that the plan would be healthy – that is, well-funded – for a very long time.
In your case, your plan would not only have to maintain its overall health until it starts paying you at age 65, you’d also want to make sure it could pay you for as long as you or your spouse are alive, which could be many decades more!
The way that a defined-benefit plan member can check on the health of their plan is to confirm the plan’s “solvency ratio.” For pension plans, the solvency ratio is the ratio of the plan’s assets to its liabilities, which are the pensions it has promised to pay.
This information can be found in the plan’s annual report, and may also be available from a plan administrator in between annual reports – and just like you’d expect, a higher ratio is better. A plan that is fully funded, with a solvency ratio of 100%, is healthier than a plan with a solvency ratio of less than 100%.
It’s important to note, however, that solvency ratios can – and do – fluctuate over time, including for reasons that are beyond the plan’s control. Changes in interest rates, in particular, can swing a plan’s solvency up or down as the “cost” of future obligations gets cheaper (when interest rates rise) or more expensive (when they fall).
In your case, Robb, the long time horizon between when you’re leaving your job (end of 2019) and when any pension payments would start (in 2045) introduces a level of uncertainty that isn’t present for someone whose pension payments would start much closer to their job-leaving date.
Even if your plan was well-funded today, were you to stay in the plan, you’d be implicitly betting that the plan would retain its health over a long time period. This makes your personal situation quite different than someone who is wondering whether to stay in their defined-benefit plan and who would start to receive benefits within the next year or so, for example.
2) Your personal financial plans
Here’s another element of your situation that sets you apart from many Canadians: you not only know and track your net worth, but you have a net worth that’s made up of more than just the value in your pension plan. Heck, just having a personal financial plan that you monitor over time makes you ahead of the pack!
What this means is that for you, the “pension decision” is much lower stakes than it would be for someone whose retirement income is mostly expected to come from their pension – or from the income they generate from a self-managed portfolio, if they commute.
Because you won’t primarily be relying on these funds to provide the income you need in retirement, no matter what decision you make, you have much more flexibility in your approach to the decision about whether to leave your funds in the plan or not.
It’s also worth noting that you are considering these funds, whether commuted or not, as a source of retirement income – versus a windfall to be spent on a blowout vacation, house upgrades, or other consumer spending.
In addition, you also have flexibility in your overall income situation – and thus your tax position – in 2020, if you choose to commute your plan entitlement. As you know, if you commute out of your plan, you’ll face a tax bill, but in your case, you can minimize the impact of the tax payable by opting to take less out of your corporation as personal compensation this year.
These features of your situation – the commuted value representing a relatively smaller proportion of your overall net worth, a long time horizon in which you could invest the commuted funds to provide retirement income, flexibility around realizing taxable income in a year during which you’d have a tax bill associated with commuting, and your high level of personal finance knowledge and investment confidence – all combine to make your situation different than someone with a shorter time horizon, little or no investing confidence or experience, no ability to manage a tax bill stemming from commuting, and a greater reliance on the pension plan (whether commuted or not) to meet income needs in retirement.
Taken all together: for you, commuting out of the plan is much less risky that it might be for the “average Canadian” – even though you’d be taking on investment risk by managing the funds yourself.
3) Understanding your pension options
As you know from my recent post about “bad pension advice” on cutthecrapinvesting.com, in my experience people seeking input for their pension decisions from financial advisors can be led astray by inexperienced, inexpert, and conflicted advisors who don’t sufficiently understand what they’re doing and the issues their client is facing.
Many times, advisors who are providing advice about pension decisions don’t really appreciate the range of options a client may have, principally the “copycat annuity” option. In addition, an advisor who is principally or entirely compensated by managing assets faces a conflict of interest, as they stand to benefit if the client commutes their pension and then has the advisor manage the assets.
In your case, Robb, you’ve reduced the overall risk that would otherwise accompany your pension decision by building your knowledge base. The fact that you are aware of the risks you’d be taking on by commuting your pension puts you ahead of many Canadians (and even some advisors), should they face the same decision.
Should you stay or should you go?
Now that I’ve reviewed the “three big issues” that someone thinking about commuting a pension needs to consider: how do they apply to your situation?
In your case, Robb, due to your individual circumstances, I think commuting is likely the optimal choice for you. You are clearly confident in your approach to investing, you’ve built up other assets so the pension’s commuted value is a relatively smaller part of your overall net worth, you are able to manage the tax bill associated with commuting – and you have many years in which to grow the value of the commuted funds to provide the retirement income you want.
Your pension plan, in contrast, doesn’t seem to be as well-prepared for your retirement as you are. The most recent public statistics I can find about its solvency (from December 31, 2018), put its funded ratio at just over 57% – an improvement from the previous year’s 53%, but not the “A+” solvency ratio of 90%+ that I’d be more comfortable with.
All in all, if you’re looking for a support from me if you choose to commute, you’ve got it! As you and I both know, each situation is individual – but your situation tips the balance in favour of commuting, in my view. So take advantage of your flexibility, preparedness and knowledge, and (in the immortal words of the Steve Miller band): Take the money and run!
Many thanks to pension expert Alexandra Macqueen for providing such a thorough and useful analysis of my pension options.
As you read this I hope it was clear just how unique each individual circumstance can be, and why generic rules of thumb cannot be applied to most pension decisions. So many variables, both personal and with respect to the pension plan, need to be considered in order to make an informed decision.
I found myself nodding along in agreement to Ms. Macqueen’s analysis of my pension decision. As you might expect, I agree with her conclusion: I’ll be taking the commuted value, transferring $134,000 into a LIRA to invest for retirement. The remaining $156,000 will be taxed and sent to me in cash.
That will change up our approach to income this year. I won’t take out any dividends from our small business this year, while we’ll lower the amount we planned to stream to my wife. This allows us to still meet our spending needs and savings goals, while leaving more money inside our small business where it’s taxed at a lower rate.
Clearly my circumstances are highly unusual. But the process of thinking through your options remains the same. Look at the health of your pension plan, the health of your personal finances, and understand the range of options available to you. When in doubt, work with an expert to help guide you through the decision.