Should You Commute Your Pension?
Question. I’ve just left my employer, and received some documents regarding my pension. In particular, I have to make a selection between 2 options – pension or commuted value. First, can you tell me what this means? And second, can you help me decide what the right choice is for me?
Answer. Great question, and although you’ve been provided this option due to termination of employment with your firm, a commuted value decision can also arise upon death of a pension plan member, or upon breakdown of a marriage or common law relationship. First of all, note that a commuted value is only applicable in the context of a defined benefit (DB) pension plan, and not with defined contribution (DC) plans. And second, what is a commuted value?
According to Investopedia, a commuted value is “the present value of the future series of cash flows required to fulfill a pension obligation. Commuted value is, therefore, the net present value of a future financial obligation.”
Let’s make sure we’re speaking in a language that everyone understands. A commuted value is a single lump sum amount, which in theory is equivalent to the value of your pension. Your pension is the regular stream of payments, typically either monthly or bi-weekly, that you would receive for the rest of your life upon retirement. You can think of the commuted value this way – What amount of money would be required, today, in order to facilitate making that stream of payments to you for the rest of your life? That amount is what’s known as the commuted value. Although different pension plans may calculate that amount differently, it is calculated by actuaries in accordance with the Canadian Institute of Actuaries’ Standards.
So the question now becomes, do you want the stream of payments for life, or do you want the lump sum? As an example, a real life decision might look something like this:
A. Pension – An annual pension of $38,570 starting at age 55
B. Commuted value – A lump sum amount of $488,562.34
Pension vs. Commuted Value
As with many decisions in personal finance, there is no universally correct answer, and different people will choose different options, and for different reasons. With that in mind, let’s take a look at some of the key considerations and trade-offs in this decision:
If you elect the commuted value option, you receive a lump sum that must be invested in a special account such as a Locked-In Retirement Account (LIRA) or Locked-In Retirement Savings Plan (LRSP). You are in full control of the investment decisions, and the options available are the same as within an RRSP. Some would rather be in control of those decisions, and others would prefer to delegate that responsibility to a professional. If you prefer control over your investments, the commuted value may be more appropriate, whereas if you prefer to be more hands off, the pension may be more attractive.
Similar to the point about control, the commuted value puts the investment decision process, and therefore the subsequent performance of the account, in your hands. If you select the commuted value, what rate of return would you have to earn to match your pension? You could have great success with your investments, and achieve a much higher retirement income. On the other hand, if you make bad investment decisions and suffer poor performance or pay high fees, you could also end up suffering in retirement. If this unknown is going to keep you up at night, perhaps the pension is the better option for you.
This refers to the health of the pension plan. For government plans, this is less of a concern, as governments have the power of taxation. However, for private companies and private pension plans, the pension promise is only as strong as the company or pension plan itself. A 100% solvency ratio means that the pension is currently fully funded, and can meet its current obligations. However, when the solvency ratio is less than 100%, as many plans are, this is called an unfunded liability, and it means that there isn’t actually enough money in the plan to pay all the retirees what they’ve been promised. Unfortunately, this reality is all too common and can cause significant hardship when a company fails like with Sears, Nortel, and Stelco.
While many pension plans have some level of indexing to inflation, others simply do not. Indexing means that the pension payments increase steadily over time. The purpose of an indexed pension is to help ensure that the retiree’s income increases along with inflation. For example, the Canada Pension Plan (CPP) and Old Age Security (OAS) plans are both indexed. In short, an indexed pension plan is generally more attractive than one that is not indexed. Be sure to keep this in mind if you select the commuted value option – you would typically want to increase your income over time, in order to offset increases in the cost of living.
Pension plans are designed to pay you a retirement income for the remainder of your life. But what happens if you die shortly after retiring? Most pension plans have a survivor benefit, typically around 50% or 60% of the original pension. For example, if you die while receiving an annual pension of $40,000, your spouse may then continue to receive $24,000 until he or she also dies. Although a survivor benefit is an attractive feature of a pension, this is a significant reduction in payments received. Essentially, if you have a shorter than average life expectancy, the commuted value option may be more advantageous. Realizing this, many pension plans have a special provision known as an SLE – Shortened Life Expectancy. If an individual has a shortened life expectancy, a commuted value option may be available where it ordinarily would not.
Not everyone is presented with the option to commute the value of their defined benefit (DB) pension. Typically, after a certain age, pension plans no longer offer a commuted value option. This varies across provincial jurisdictions, as well as pension plans, as some plans are more generous than others when it comes to presenting options to members.
How can you decide which is the right choice for you? Unfortunately, most companies and pension plans offer no advice in this area, and simply suggest you speak with an advisor. Which is exactly what you should do – Deciding whether or not to commute the value of your pension is an important decision that should be made with the help of a professional.
Are you faced with a decision regarding your pension? If you want to speak with a professional advisor, or if you have any other questions about pensions, retirement, or any of our services at ModernAdvisor, just contact us.