Commuting a Pension
When leaving an employer, you are faced with an important decision: to leave your pension funds with your former employer, transfer your pension to your new employer, or commute their pension. Commuting a pension provides peace of mind and control over pension funds, with the potential to care for your beneficiaries should the unexpected occur.
Know Your Options for Commuting a Pension
When you are ready to retire, or you are leaving your job with a defined-benefit pension for a different job, then you have a few different options for the funds that have accumulated in your pension plan:
- Leave the pension in place. Although you won’t be working at your job anymore, you can still leave the funds accumulated in your pension plan where they are. Once you are eligible based on your age and the pension plan rules, you can receive a monthly income. Your employer will provide information about when your income would start paying out, how much the monthly income payment would be, and the data used to determine your monthly amount.
- Transfer your pension to a new defined-benefit pension plan. If you are moving from one job with a defined-benefit pension to a different position with a defined-benefit pension, you can transfer the pension funds you accumulated at the first job to the new one. This option will depend on the details of each pension plan.
- Commute your pension. Also called “cashing out” your pension, this option involves taking the funds out of your pension in one lump sum. The pension plan would be transferred to a Locked-In Retirement Account (LIRA) up to the Maximum Transfer Value, a limit set by the Income Tax Act. Any amount greater than the Maximum Transfer Value would be paid out to you as taxable cash and can be contributed to a Registered Retirement Savings Account (RRSP). Another option is that the pension funds can be used to purchase a life annuity from a life insurance company. This is called a copycat annuity.
The stakes for this decision can be high since your choice is irreversible, the value of your pension can be significant, and you may not have much time to decide. A financial advisor at Harmer Wealth Management can walk you through your choices and help you commute your pension.
Benefits of Commuting Your Pension
Your pension funds are more accessible under the rules for LIRAs, including unlocking provisions. Depending on your jurisdiction, once you reach a certain age, you can unlock up to half of the LIRA’s value and move it into an RRSP. An RRSP has no limit on how much can be withdrawn, so if you want more flexibility with your money than receiving a monthly pension, commuting your pension can be a wise financial decision.
You can manage and invest the money directly for a higher return. Those who opt for a monthly pension payment have little to no say in how their plan is invested. You can manage your investment directly and get much higher returns if you commute your pension.
You avoid the risk that the pension plan becomes insolvent. When companies go out of business and leave their pension plans underfunded, retirees are the ones that suffer the most. If you are concerned about the long-term viability of your employer and your pension plan, it might be best to commute your pension so that you have more control.
If you die early in retirement, the remaining account balance can be left to your beneficiaries. With a pension plan, your spouse can continue to receive 60 percent of the amount you were receiving following your death. However, once your spouse dies, your beneficiaries have nothing left. If you commute your pension, the remaining balance will be left to your spouse tax-free; once your spouse dies, the remaining balance will go to your beneficiaries tax-payable.
Get Started Commuting Your Pension with a Financial Advisor
A big decision like whether to commute your pension should not be made lightly. The financial advisors at Harmer Wealth Management can help you review your pension details and the choices available to help you make the best decision about your pension funds. Contact us today to begin the process of commuting your pension.
Commuting a Pension FAQ
What does commuting a pension mean?
When an employee retires, they have two options: either receive fixed, regular payments that guarantee them a source of monthly income, or they can take a lump sum from their plan. Commuting a pension means taking out your pension as one lump sum instead of receiving a monthly payment for your life upon retirement. The value of the lump sum payment is called the commuted value.
What is the commuted value of a pension?
The commuted value of a pension refers to the estimated cost that an organization needs to fulfill its pension obligations if they are paid out in a lump sum. The value is estimated based on factors such as the age at which the employee is retiring, the future life expectancy of the former employee, and the rate of return (RoR) that can be expected if the lump sum is invested.
How is the commuted value of a pension calculated?
To calculate the annual benefit pension payable to the employee, the commuted value is divided by the employee’s life expectancy. The formula typically used to calculate commuted value is PV = FV / (1 + k)^n. However, each company has slightly different ways of calculating the commuted value of a pension, so it is best to request an estimate from your employer. They will calculate the commuted value of the pension for you and send an estimate for your review.
What are the advantages and disadvantages of commuting a pension?
Here are the advantages of commuting a pension:
- The money in your plan is easily accessible and can be used to meet other financial goals than providing retirement income.
- The funds can be managed directly in your locked-in account, meaning you can take investment risks as you choose.
- If you pass away earlier in retirement, the remaining value of your commuted pension can be left to your beneficiaries.
Here are the disadvantages of commuting a pension:
- Without a financial plan, you may be tempted to deplete the funds and put them towards other goals, meaning that you might be short on retirement funds.
- Usually, the amounts you invest on your own don’t have the same guarantees as the payments from a pension plan.
- Market downturns just before or early in retirements, when withdrawals start, could limit the retirement income your commuted value can produce.
What are the advantages and disadvantages of leaving a pension in place?
Here are the advantages of leaving a pension in place:
- The pension will pay every month for as long as you live, even if that is many years after retirement.
- If your pension benefit is indexed for inflation, it will increase as the cost of living increases.
- If you have a spouse or common-law partner, the pension can continue to pay for them at a reduced rate after you pass away.
- There are no investment decisions or investment risks.
Here are the disadvantages of leaving a pension in place:
- The money in the plan is not liquid but is paid out month to month.
- The pension has no estate value after you and your spouse pass away.
What is a copycat annuity?
A copycat annuity is a type of pension commutation in which the entire commuted value is commuted to an insurance company and buys you an annuity contract that materially gives you the same rights you would have under the pension plan. It gives you a pension plan without subjecting you to uncertainties brought on by poor management from your employer. If you have fears that your pension could be in jeopardy, then commuting your pension and buying a new one with an insurance company might be a better option.
Contact Harmer Wealth Management to learn more. We’re Durham Region and Northumberland County’s trusted financial advisors.
We’re Durham Region and Northumberland County’s trusted financial advisors.
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