There are so few guarantees in life. Why would anyone fortunate enough to have a pension take a lump-sum payment instead?
Cue the chorus of responses.
Maybe the employer is going through financial straits and the pension doesn’t look sound. Maybe the recipient is thinking about his or her estate and wants to leave the cash to family members. Maybe the investing-savvy think they could do a better job of managing the money.
In fact, taking the lump sum, or commuted value, looks even more attractive when short-term interest rates and bond yields are low, as they are now. The lower they are, the higher the payout will be. (That is because when fixed-income returns are low, a guaranteed, direct-benefit pension plan needs more money earlier to meet expected payouts later.)
“There is a temptation because of the low interest rates and the correspondingly higher amounts [of pension money] available,” said Darryl Robinson, financial planner at D. Robinson and Associates Inc. in Winnipeg.
Yet Mr. Robinson immediately warned of the large bite that income taxes take from the lump-sum amount in the year of receipt.
“Many people are of the mistaken belief that the amount of money available to them is simply their portion of the pension and the company’s portion of the pension added together. And that’s of course not the case,” Mr. Robinson said.
Taxes are critical when calculating what will be left over.
“That’s where I start with people, to understand what they are going to be left with to invest,” Mr. Robinson said. “We start not from the gross amount, but from the net amount that would be available for investment. Then we start looking at what we can generate on that available income,” and how it stacks up against the pension plan itself.
The catch is that when commuted pension values are high, so are the taxes, Mr. Robinson said. Clients can be surprised to learn that hundreds of thousands of those dollars may be subject to tax, he warned.
Some of that taxable portion of the commuted pension could be put into a registered retirement savings plan (RRSP), but few employees who have pension plans have the needed amount of RRSP contribution room, Mr. Robinson said.
It’s vital to know, too, that every pension has its own set of rules and is subject to provincial or federal regulations, which determine when or if an employee is able to take the lump sum. An employee of a private company may not have a choice after an early retirement deadline of, say, age 50 or 55. The logic is that no company wants a rush of employees all withdrawing their commuted pensions at the same time.
Despite the potential downsides, some soon-to-be pensioners may still want to invest the commuted value themselves or use a financial adviser. Any lump sum from a pension has to be put into a vehicle such as locked-in retirement account (LIRA), in which you have investment choices, and where the money is held until retirement.
Upon retirement, this account can then be converted into a retirement income account, from which income is generated. One traditional option used to be an annuity with a guaranteed rate of return. But “the reason you don’t do that today is because it’s not 1985. We’re at historically low interest rates,” said Nathan Parkhouse of Parkhouse Financial in Toronto. “People are avoiding that like the plague today because the rates are too low.”
Pension recipients can also choose hybrid investment vehicles such as guaranteed minimum withdrawal benefit plans, which are similar to annuities but also act like investment funds to take advantage of market gains.
Deciding whether to take a lump sum can go beyond tax or investment considerations, however. “Sometimes you just have personal reasons to do it that have nothing to do with tax or rate of return or any of those things,” said Daryl Diamond at Diamond Retirement Planning in Winnipeg.
“We had a gentleman who worked for one of the national railways. And our view after going through the numbers was, ‘We don’t want you to do this.’” But he decided to do it anyway. Mr. Diamond recalled the man saying that he wanted “a legacy there for both my wife in terms of income, and ultimately something residual from that capital asset that will go to the kids.”
Too often, though, employees may not be aware of their pension’s rules and don’t realize that they need to make lump-sum decision well before retirement. “It’s not the kind of decision that one should be looking at weeks in advance of the deadline. [It should be] really months or perhaps even years in advance,” Mr. Robinson said.
It’s also easy to be dazzled by such a large sum of money. Just remember the taxes, Mr. Robinson said. “Understand what the tax implications are, and whether it’s right for them.”Report Typo/Error