Many people believe that when leaving a job with a defined-benefit pension, their options are limited to commuting the pension – taking its value as a lump sum – or leaving it with your former employer.
But if you're concerned about the long-term financial health of your employer-sponsored pension plan, neither of these two options may sit well with you, says Lea Koiv, a Toronto-based accountant who specializes in retirement and pension advice.
On the one hand, you might be afraid that if you leave your money with your former employer they won't meet their pension commitments, she says. Sears Canada is just one of the most recent examples of a company whose former employees are seeing their pension payouts slashed or lost altogether.
But, on the other hand, Ms. Koiv says, you face "market and longevity risk, and possibly a big tax bill, if you commute the pension and take your chances."
There may be another option, however, for ensuring you have lifelong income: commuting the pension to a "copycat" annuity purchased from a life insurance company that mirrors the provisions of the employer pension plan.
Copying the pension rights means the annuity must provide the same or very similar options and guarantees as the pension, such as early-retirement benefits, inflation indexing and survivor benefits for a spouse or child. The copycat annuity isn't an off-the-shelf product, but a strategy that uses a life annuity purchased from a life insurance company to mimic the company pension. The insurer typically has to prepare a custom quote.
Annuities are unpopular with Canadians, in part because once you buy one, you cannot sell it or cash it in, as you could with, say, an RRSP. But an annuity provides you with the same thing a defined-benefit pension does – guaranteed income for life, with no investment risk.
"Think about employees with [defined-benefit] plans at companies facing financial trouble, such as Sears Canada or Massey-Ferguson," says Bill Kennedy, a pension actuary at Lesniewski Moore Consulting Group. "If the company goes belly-up, the security of that pension income can disappear. I suspect some of those employees wish they'd taken the annuity option that preserves their retirement income."
With a defined-benefit pension, contributions are made over your working life to build up the account that will give you the income you need once you retire. With most life annuities, you make a lump-sum contribution in exchange for monthly income for life.
If you've worked for many years with a defined-benefit pension, it may have grown to a considerable value, and half its value or more might be taxable if the pension is commuted as a lump sum. That's because of income-tax rules which limit the amount you can transfer from a pension to a tax-sheltered account, such as a locked-in retirement account. Any amount that's above the maximum allowable transfer value is taxed like employment income in the year it's received. There's generally no option to commute part of the pension to limit the tax hit; you must either commute the full value or leave your funds in the plan to be paid out as a pension.
In a recent case Ms. Koiv reviewed, a pension that paid $4,600 a month to start, rising with inflation over time, had a commuted value of $1.6-million, but the amount that could be transferred to a tax-sheltered account was approximately$600,000. This meant that if the employee commuted her pension as a lump sum, she'd get a tax bill of approximately $500,000 on the remaining $1-million.
However, if she chose to buy a copycat annuity to mirror the pension benefit, she could avoid the tax bill and retain an income for life that isn't subject to market fluctuations. If the commuted value is not enough to let the plan member buy an annuity that fully mimics what the plan would have provided, the Canada Revenue Agency will still allow it provided the annuity is not "materially different" from what the plan would have provided.
And because the income is from an annuity, it may be covered by a customer protection plan called Assuris, which steps in to protect pension income if a life insurance company fails. Assuris covers up to $2,000 a month, or 85 per cent of the promised monthly income benefit, whichever is larger. In this case, more than one annuity could be used to provide the monthly income benefit, ensuring all of the income would be covered by Assuris.
The option to commute a defined-benefit pension plan to a copycat annuity will depend on the provisions of the pension plan, as well as your individual situation. You may, for example, need to not be within 10 years of retirement age. Although pensions across Canada vary, most of the plans Ms. Koiv has reviewed that permit the member to commute allow the copycat annuity option.
Financial adviser Jason Pereira, a fee-based Toronto financial planner at Woodgate Financial & IPC Securities, who recently helped a client get a copycat annuity, says this option is "frontier territory – so new, it's not in any textbook." That's because this strategy, outlined in the Income Tax Act, had not been used because of conflicts between the tax and pension legislation. Those conflicts have now been resolved. While the Canada Revenue Agency permits the strategy, few pension specialists may be aware of it.
Mr. Pereira is hopeful that pension documents will eventually provide copycat annuities as an option for employees leaving a defined-benefit plan. But for now, most people would have to find an adviser who not only knows about the option and how to put it in place, but one who is also willing to recommend an annuity, even though it means they might earn less compared with putting the funds in a portfolio they manage for the client. Mr. Pereira says he often suggests his clients get an independent review from an impartial expert, such as a pension actuary.
For employees at or nearing retirement who have concerns about the financial viability of their employer defined-benefit pension plan or those who face a significant tax bill if they were to commute their defined-benefit pension plan, a copycat annuity strategy may be the answer.