My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with BDO. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. My posts are blunt, opinionated and even have a twist of humour/sarcasm. You've been warned. Please note the blog posts are time sensitive and subject to changes in legislation or law.

Monday, June 3, 2019

Should I commute my pension?

Defined benefit pension plans make some people very happy – and others just a bit jealous. But they’re not all fun and games. Their recipients – and the recipients’ families – must ask themselves several questions when they leave their job. Here is a key one: should I take the defined benefit or go for the commuted value?

Some people may ask, aren’t defined benefit plans a thing of the past? Yes and no. While the number of defined benefit plans offered by private sector employers in Canada has declined over the last 10 to 15 years, they still play a vital role in the retirement of over 4 million Canadians, according to 2016 Statscan figures. They also remain de rigueur in the public sector.

Today, BDO’s Tom Mathies – Senior Advisor, Wealth Advisory Services – drops by Blunt Bean Counter to analyze whether you should keep the pension as is or take the commuted value as a lump sum.
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The families my team deals with on a daily basis ask many questions about retirement. Often they boil down to one simple concern: “Where do I get my ‘next’ paycheck from?” That’s why the question of defined benefit vs. commuted value is so crucial. By taking the commuted value, people add a variable into the certainty of a defined benefit pension.

Figuring out where to start can be overwhelming for many. We recommend keeping track of your spending for six months to a year before retirement. This helps you understand your spending decisions by looking at your long-term habits and trends. It serves as a first step in deciding whether to commute your pension.

Aside from spending habits, the factors in deciding whether to take the commuted value over the defined pension are as varied as the number of Canadian families. There is no universal rule to make this an easy choice. However, let’s discuss a few of the considerations.

What is a defined benefit plan?


A defined benefit plan provides a predetermined monthly income after retirement based on the formula stated in the plan. Typical factors in determining the benefit include number of years of service, age at retirement, amount of the contributions into the plan, and average income.

Many people believe that having a defined benefit pension is the retirement equivalent of receiving Willy Wonka’s “golden ticket.” These plans do provide peace of mind and potential income security. However, they are not foolproof. Cautionary tales like the Sears bankruptcy – though anomalies - illustrate how fragile defined benefit guarantees are for pensioners.

In addition, governments provide little protection in case the company goes belly-up. Ontario is the only province to provide such a guarantee, through its Pension Benefits Guarantee Fund.

Bridge benefit


To support retirees who retire early, many defined benefit plans offer a bridge benefit option. This bridges the gap years until age 65, when many people start receiving Canada Pension Plan (CPP) benefits. While Canadians can choose age 60 as their start date, they will receive lower individual payments than if they begin later.

Bridge benefit payments are considered an additional benefit above the calculated lifetime pension. If retirees commute their pension, they don’t receive the bridge benefit. Some pensioners choose to receive their reduced CPP benefit while also receiving a bridge benefit. Old Age Security (OAS) benefits also often begin at age 65 and will therefore replace some of the bridge benefit.

We urge people to consider all of their taxable income when applying for OAS, as OAS benefits are reduced when net income exceeds $77,580. If net income reaches $125,696 in 2019, OAS will be fully clawed back beginning July 2020. For those pensioners with higher income between ages 65 and 69, OAS can now be deferred to age 70. Those pensioners who opt to defer to age 70 will receive a benefit that could be as much as 36% greater than those who elect to take OAS at 65.

Survivor benefits


Defined benefit plans also offer a number of survivor benefit options in case the pensioner passes away after retirement. These ensure at least 66.67% of the monthly pension is available to their spouse. Pensioners may instead choose a survivor pension that provides a greater percentage - 80% or 100% - of the monthly benefit. If you choose a higher survivor benefit, the monthly pension will be lower to accommodate for the increased benefit to your spouse. The survivor options for loved ones of a pensioner who dies before retirement, or for a pensioner who dies without a spouse in retirement, vary based on the pension.

What is the commuted value?


People who decide their commute their defined benefit pension receive a lump sum amount instead of a monthly payout.

The commuted value of an individual’s pension is calculated by an actuary. It represents the net present value of the future obligation to fund a retirement benefit, based on the years of service and lifetime average income earned during the years of membership in the pension, to use the description of Fraser Lang of GBL Inc. Once calculated, a portion of the commuted value can be transferred to a locked-in retirement account (LIRA), and the balance comes out as taxable income. Every pension calculates the commuted value differently.

Consider a pension that pays $70,000 per year for life. What size portfolio would one need to generate that kind of income? Using the 4% rule, you would need a portfolio of $1.75 million to maintain your principal. So would a pensioner be further ahead by taking the commuted value?

In this example, the commuted value would be about $2 million. Of this value, approximately $650,000 would be eligible for transfer to a LIRA, and the balance comes to the pensioner as taxable income. After paying tax, they will be left with about $1.35 million in a mix of registered and non-registered money.

One note of warning: commuting a pension provides the recipient with liquidity, but also with a potentially large tax bill.

Defined benefit vs. commuted value


Deciding between taking the relative safety of a defined benefit and the lump sum of commuted value demands that you ask some tough questions:
  • Are you a person who needs the structure of a defined budget to keep you on track?
  • Do you like the idea of predetermined income for yourself and your spouse in case you pass away first?
  • Do you believe your company or organization is in a good position to fund pension liabilities for many years to come?
  • Is the defined benefit indexed to inflation?
  • Is the defined benefit plan underfunded?
  • Does the plan provide a greater benefit than what could be reasonably achieved in other stock or bond investments?
  • Do you require immediate liquidity?
  • Would you rather invest the funds directly or with the help of an advisor – or leave them in the plan?
  • Would you like to leave an inheritance for the next generation without purchasing a life insurance policy?
Deciding between keeping the defined benefit and choosing the commuted value can be one of the toughest decision retirees make. In the end, the answer will often come down to those familiar investment variables – lifestyle, risk profile, and finances.

Tom Mathies is a senior advisor in the Wealth Advisory Services practice at BDO. He can be reached at tmathies@bdo.ca, or by phone at 519-432-5534.

The content on this blog has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The blog cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information on this blog or for any decision based on it.

Please note the blog posts are time sensitive and subject to changes in legislation.

BDO Canada LLP, a Canadian limited liability partnership, is a member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms.

2 comments:

  1. IMO, those fortunate enough to have a defined benefit plan should not mess with it ... why increase risk at this point in your life.

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    Replies
    1. The CPP is a defined benefit plan of a minor sort that is indexed to inflation as well. The OAS plan is also helpful as a framework to build upon. If you have a defined benefit plan of any sort this is flesh on the bones of the public retirement system.

      The best situation would be to have a defined benefit plan and put the rest of any savings into a TFSA and a RRSP

      You can keep contributing to the TFSA without stopping at age 71 as you have to for the RRSP. This means that you could (if you don't need the money) take the RRIF money and invest it in your TFSA. Since citizens are living longer, it seems prudent to hedge one's bets by having money in the TFSA to add to any pension or RRIF money.

      All this saving can be bothersome and also lead to penny pinching that can be hard to bear but such deferred gratification can also lead to a pleasant retirement if you aren't bedeviled with health concerns and threat of an immediate demise.

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