Careful consideration required before commuting a pension plan

By Susan Yellin | June 18 2013 06:50PM

With interest rates stubbornly low and the future of Canada’s pension plan system anyone’s guess, those who have the option of swapping their future defined benefit (DB) pension payments from their current pension fund for a lump-sum today have a number of issues to consider.Taking the lump sum – known as commuting a DB plan – and transferring a prescribed amount to another tax-free registered vehicle, typically takes place when a person terminates employment. The transferred amount often remains locked in until the person turns 65.

The most troublesome part of making the decision on whether to commute the pension involves more than just numbers, said Ian Burns, a financial advisor with The Pension Specialists, Investment Planning Counsel of Canada.

“The whole thing is very nebulous because today things can change in just a heartbeat,” said Mr. Burns. “The toughest thing is to be very objective. Your pension options are a real emotional decision.”

Pension actuary Malcolm Hamilton says employees first need to determine whether the amount of the commuted value is enough to meet their needs. If they don’t take the commuted value, how confident are they that they will be able to get their money down the road if they leave it with the company.

So, if an employee believes that over the next 20 years or so the company could go out of business, or if its pension plan was in a deficit position, he might decide to invest the money himself.

“If you’re working for an organization that is weak and typically has troubles in economic downturns, then that would argue for taking the money when you can get it,” says Mr. Hamilton, also a senior fellow at the C.D. Howe Institute.

But Mr. Hamilton notes the company’s trouble with its pension plan could multiply if everyone in the company thinks the same way. “Let’s say you were in a pension plan of a troubled company and you started reading in the paper [rumours] that the company was going to fail and you knew the pension plan was badly funded. If you could quit tomorrow and get all your money out then there would be a rush for the exit and it would be to the detriment of the people who don’t leave,” said Mr. Hamilton.

An employee might also feel that the company will change benefits down the line – maybe remove the cost of living or reduce survivor benefits, both potential incentives to commute, said Mr. Burns. “Nortel springs to mind as one of these companies where people thought they were getting something and ended up with something else.”

The current value of the commuted pension is based on standards developed by the Canadian Institute of Actuaries and will represent fair value for the pension, said Mr. Hamilton. However, there are those who need the money immediately or are interested in investing on their own.

If there are no worries about the future of the employer, then it might be better to leave the money where it is with that fair value guarantee, said Mr. Hamilton. Left with the employer, “this isn’t an instrument where you have any investment risk. The only risk you really have is whether the benefit will be paid at the end of the day.” In fact, many people look forward to a guaranteed income stream and are comforted by a regular cheque.

But there are those who might want to commute their pension before they retire because they don’t have a surviving spouse or survivor benefits. Typically, when a pensioner dies prematurely and there is no spouse, any unused pension benefits revert to the pension plan, said Mr. Burns.

Life expectancy

As well, there are those who may, unfortunately, be experiencing ill health at the time they decide to commute their pension. As a rule, says Mr. Hamilton, these people may want to take the money immediately because the amount being offered is “pretty generous” considering that the amount is calculated for those with normal life expectancies. On the flip side, those who expect to live longer than normal should be inclined to leave the money where it is because they will get to collect a pension as long as they live.

The Income Tax Act has set a limit on the amount that can be transferred tax free to another registered plan. Tax considerations have to be taken into account if the person decides to take out more than the limit. Transferring over that limit might trigger taxes.

In addition, some pension plans either have or may be planning on putting in their own restrictions. “What we’re going to see moving forward is companies changing the commuted value options. For example, the Ontario Teachers’ Pension Plan does not allow you to complete a transfer after age 50. But most pension plans allow you to commute to within 10 years of your normal retirement age,” said Mr. Burns.

As well, if a DB plan is only 60 per cent funded, and the plan is wound up or terminated, the employee might only receive 60 per cent when commuting the pension, he said. (In Ontario, the balance is typically paid out within five years of termination.)

Current low interest rates are also an inducement for some to commute their pensions, especially if they’re confident that rates will rise significantly over the next few years from current historically low rates. “You can take your pot of money, don’t lock in today’s low returns for 20 or 30 years by buying long-term bonds [but instead] invest it in short term vehicles,” suggested Mr. Hamilton. “While you won’t get much for the next few years, if you think interest rates will rise then you will make substantially better returns than two, three or four per cent.”

Keeping health and dental benefits are also a plus in staying with a company. As people age, costs for these items can rise significantly and if the plan has these pluses, they make a good incentive to stay put. Indexed pensions are another reason to remain in the plan, although Mr. Burns said there is a trend among some plans to start removing benefits, one of which could be indexation. For example, the Ontario government and the Ontario Teachers’ Federation recently agreed to eliminate the guarantee that members’ benefits will be adjusted for inflation and increased contributions.

Most Canadians – if they have an employer-sponsored plan of any sort – generally have defined contribution plans (DC) and in a DC plan there really isn’t a commuted value. “You just have an account balance and typically you know how much came from your contribution and how much came from the employer.” Once an employee in a DC plan puts in enough years to become vested, he can get all of his money and the contributions the employer put in, but the funds generally remain locked-in until 65, said Mr. Hamilton.

At the end of the day, each employee is different with separate wants and needs.

The best option, said Mr. Burns, is to ask a knowledgeable financial advisor to create a financial plan and analysis, because once a person commutes the value of their pension, there’s no going back.