What you should know when you have a pension through your employer!
Brendan Greenwood CIM, QAFP, B.Comm | December 4, 2020
The challenges of this past year have forced many of us to evaluate and start to make decisions about how we are living. These can include major life decisions like buying a home away from the city, leaving a job or an unhealthy relationship, getting married or having a child, maybe starting a business.
For me, many of these important life decisions were discussed this summer on the golf course. One of these discussions related to a semi-retired friend who was considering cashing out his defined benefit pension plan. His plan was to use the money to buy another property and invest the balance in the stock market. He was concerned about the tax he would have to pay.
It is understandable that tax would be a concern. When commuting a pension, often only a portion of it called the maximum transfer value (MTV) can be moved tax free into an RRSP, DPSP or defined contribution Registered Pension Plan (RPP). Anything above the MTV is taxed as regular income. In many cases there could be several hundreds of thousands of dollars subject to income tax and if you have already earned substantial income in the year you may be looking at a lot of money being taxed at a rate of over 50%.
There is not much that can be done to avoid having the dollar amount in excess of the MTV included in your taxable income in the year you commute your pension. You may have some additional RRSP room after factoring in your pension adjustments if you have not made full use of your available RRSP contribution room over the years. The only other options to avoid this money being included in taxable income is to buy an annuity. In this individual’s situation that would not have accomplished what they wanted to do, buy a property and invest the difference in the stock market.
Beyond tax though, there are many other issues that should be considered when deciding on whether to commute a pension, here are some important ones:
1) Where are interest rates currently? Generally, commuted values are calculated using a Government of Canada bond yield plus a spread. Considering that this is how pension liabilities are determined, lower interest rates generally result in larger commuted values for the plan member. This factor alone can make it very attractive to consider commuting a pension in a low interest rate environment like the one we are in today.
2) What is the financial condition of the company or organization? Many public pension plans are well funded, but when private companies run into solvency issues this can lead to a plan member receiving much less than 100% of their promised pension.
3) Do you know your annual retirement income needs and life expectancy? Will your pension provide you with most of this income? If the pension sponsor is financially sound, a pension can provide a predictable source of income, that may even have inflation protection built into it. For more risk averse individuals that do not have other income sources they can rely on in retirement keeping your pension can make a lot of sense.
4) Does your pension come with any health benefits? Members of some pension plans enjoy considerable health benefits. It is important to understand any health benefits tied to your pension and their potential value to you before deciding to commute your pension.
5) How important is it that some of the money goes to your children when you pass away? With pensions there is usually a 60% spousal survivor benefit. Most employer pension plans do not have any provisions to pass on money to your children so when you’re spouse dies the pension and its distributions end.
This list is not exhaustive. Speaking to an advisor can help ensure you make the best decisions based on your personal circumstances and desired outcome. The pandemic has people asking serious questions about the future course of their lives and a financial professional can help navigate unfamiliar territory.
Brendan Greenwood is an Investment Advisor with Worldsource Securities focused on personal pension strategies and leveraging technology to provide progressive institutional style investment solutions for professionals, incorporated individuals, business owners, retirees and their families.
For other articles authored by Brendan Greenwood on issues impacting business owners and individual investors see https://www.greenwoodwealth.co/blog.
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