Guaranteed monthly payments for as long as you live, or a lump sum today? If you have a defined benefit pension plan, that question may be on your mind as you consider whether to leave the pension in place, or remove your funds from the plan and go it alone.
Over the past decade, with life expectancy gaining ground each year, the value of a defined benefit pension plan has increased. At the same time, though, increased life expectancy and low interest rates have also contributed to a decline in the overall "health" of defined benefit plans.
For example, in recent years the Canadian media has reported on the underfunded status of defined benefit plans for large employers, such as Canada Post Corp., and, in the direst cases, the uncertain status of pension payments for a plan where the employer has gone bankrupt, such as Nortel Networks Corp.
Taken together, employees with defined benefit pension plans may be weighing the benefit of a large lump sum available today versus a stream of payments that may have some risk of falling short of the pledged amount.
Understanding pension values
If you're thinking about retirement and contemplating whether to take or exit your defined benefit pension plan, you can ask your pension administrator for your options at retirement, which may include the option to take the funds out as a single lump sum amount.
That amount is called the "commuted value," and it represents the amount today required to fulfill the pension's future monthly payment obligations to you. Its value is based on assumptions such as how long you might live, whether you're male or female, whether you're retiring early or at the normal retirement age set out in your plan, what long-term interest rates and inflation rates might look like, and specific features of your pension plan, including whether it would pay a survivor pension to a spouse if you predecease them.
In order to take your funds out of the plan, generally you have to either retire or terminate your employment. However, even in these circumstances, a lump sum commuted value is not always available.
In theory, because the commuted value of your plan (if you leave) is equal to the expected value you'd receive if you stay, you should have no financial preference between the two options. However, the choice is rarely that simple. What are the issues you should consider if this is a decision you're facing? We checked with a few pension specialists to ask their opinion about how to deal with the "leave or stay" decision.
Commuting a pension: Can you and should you?
"The first thing to confirm is in what circumstances your plan actually allows you to take the commuted value," says Lea Koiv at Lea Koiv and Associates, a CPA and Toronto-based specialist in pension matters. "Then, once you've determined if you can commute your plan participation, the next question is whether you should. In order to make that decision, there are a lot of issues to consider, some of which may not be obvious.
"A big issue to clarify if you're thinking about commuting a pension is the tax implications," adds Ms. Koiv. "When you take the value of your pension as a single sum in one year, that amount often exceeds what you can transfer to tax-sheltered accounts. This means you'd need to pay tax on the extra amount. For some plans, which have particularly generous benefits, such as early retirement, bridge benefits and inflation protection, it is not uncommon to see 60 per cent or more of the lump-sum value be taxable income. And because commuted values in some plans can be in excess of $1- to $2-million, you can be looking at a very hefty tax bill, especially since many jurisdictions have top marginal tax rates that are in excess of 50 per cent."
Independent advice is key
Financial adviser Jason Pereira, partner and senior financial consultant at the financial planning firm Woodgate Financial Inc. in Toronto, refers his clients' questions about whether to commute a defined benefit pension plan to an independent financial planner with an actuarial background. That planner, in turn, prepares a detailed report comparing the two options and providing pros and cons for each.
A recent report prepared for one of Mr. Pereira's clients by Toronto-based planner Patrick Longhurst identified a number of "generally-accepted pros and cons" for taking a lump-sum versus remaining in the plan.
Pros for the lump sum identified by Mr. Longhurst include the flexibility to begin payments when required (subject to any locking-in provisions), control over the investment assets, and the potential for assets remaining at the death of the plan member to become part of their estate. On the other hand, pros for the pension option include the guarantee of payments continuing for the balance of the member's lifetime, the potential for spousal benefits and the ability to opt for pension income splitting before the age of 65 (except for provincial tax purposes in Quebec.)
"In the current economic environment," notes Mr. Longhurst, "the wild card is frequently the funded status of the pension plan and the risk that the promised benefits may not be paid in full." This risk, however, must be balanced against the chance that when funds are transferred out of the plan, they may now face investment risk – thus the importance of ensuring the funds are well managed, whether as a DIY investor or with professional help.
A third option: copy-cat annuities
For Canadians contemplating commuting a pension and potentially facing the choice between uncertain payouts from a defined benefit pension (if the solvency of the plan is in question) and a large tax bill plus investment risk if the funds are invested (if the plan is commuted), a third option may provide a solution.
Under section 147.4(1) of the Income Tax Act, a pension plan member can transfer their entitlement under the plan to what's commonly known as a "copy-cat annuity" offered by a life insurance company. If the pension plan allows for this, it allows a plan member to create a pension-like stream of income in retirement while locking in the present value of their plan benefit, which might fall if interest rates rise, or may become less certain if the funded status of the plan declines.
It also allows the plan member to avoid the tax they would pay on the commuted value, as none of the plan benefit is taken into yearly taxable income if the funds are directly transferred to an "equivalent" annuity. (If the cost of the copy-cat annuity is less than the commuted value, the excess amount may be refunded to the plan member.)
In order for a pension plan member to make a tax-free transfer of the commuted value of their plan to a copy-cat annuity, it is critical that the rights under the annuity contract not be "materially different" from the rights under the pension plan. This typically means that a life insurer will have to provide a custom quote, versus using an off-the-shelf product – which may explain why knowledge of this option is low.
"For some plan members," comments Ms. Koiv, "they'd prefer to receive a monthly income in retirement, versus taking on the risk associated with having their money invested in the market. The copy-cat annuity provides a way to replicate the benefits the pension plan would have paid in retirement while retaining the current high commuted value of a plan and avoiding a high tax bill. Moreover, longevity risk is eliminated."
So if you're near retirement and thinking about whether to stay in or exit your plan, what should you do? Perhaps the most important step is to "get good unbiased professional advice on this point," Ms. Koiv says. "Ideally, you'll want to start looking at your options a full decade before retirement, as not all defined benefit pension plans allow members to leave the plan and take a lump sum if they're within 10 years of retirement."