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Sudden Wealth: Pensions

Insights Sudden Wealth

If you've thought about unlocking your pension, it could be the largest financial decision of your life.  

Although the availability of pension plans has been in the decline for workers for years, private pension plans continue to be a significant source of retirement income for many Canadians.  The decisions you make regarding your pensions as you reach retirement can have a significant effect on your long-term wealth, and like many decisions at retirement, they're permanent.  

There are two main types of pension plans, and it is important that you know which one you are dealing with.  

1. Defined Benefit Pension Plan (DBPP)

In a Defined Benefit Pension Plan you and your employer both make contributions to the plan, but the employer is 100% responsible for making your pension payments to you according to a formula, regardless of whether the pension is fully funded or not.  The employer also makes the investments decisions, you do not bear this responsibility.  Typically these pensions are hard to find these days other than within government or large and old companies like Bell Canada or GM, and most of those companies have stopped offering DBPPs. 
If you have a defined benefit pension plan then it is so rare and valuable that it is often referred to as "golden handcuffs." 
2. Defined Contribution Pension Plan (DCPP)

In a Defined Contribution Pension Plan, you and your employer both make contributions, but YOU are responsible for for all of the investment decisions, and if they go poorly the company won't be making up for any losses.  You bear the the responsibility for the investment decisions and outcomes.  These DCPPs are more popular than DBPPs and are easy to differentiate because you would receive at least an annual statement that shows the balance of your pension and its current investments.

Should you Commute?

No, I'm not talking about the time you spend in your car.  Commuting your pension is an option that some employees will receive when they retire, or when switching companies.  A commuted value is simply the lump sum of money from a DBPP today, which is intended to be equivalent to your lifetime of payments.  Typically a portion of the money needs to be transferred to a Locked-In Retirement Account (LIRA) and a portion can be contributed to your RRSP if you have room, or taken as income.  

So commuting your pension is deciding to take a lump sum instead of a monthly pension for life.  Why would someone do this?  There are several good reasons to consider commuting your pension. 

1. You can take advantage of tax efficiencies.   You pay some tax up front when you commute a pension, but then you tend to pay less tax over time because you can use tax reduction strategies, like TFSAs or tax advantaged investments.  

2. You can invest how you want.   Some people would prefer to be more aggressive with their investments and therefore could expect to earn more money if they commute their pension and invest rather than relying on the monthly income.

3. You have more control over what you do with the money.  Want to donate it to a charity or to your kids?  It's hard to do that with a monthly cheque, but much easier when you control a lump sum.  

4. You have more control over your estate.  If you keep your monthly pension, you only have a short guarantee period and then if you pass away your spouse may be entitled to a partial benefit, but if your spouse passes first or you don't have one then the income stops.  Even if you do have a spouse, if you wanted some of that money to go to charity or your kids, you don't have that control.  With a commuted value you can name specific beneficiaries for the money that remains when you pass.

Naturally, the offsetting risk to all of this control is that if you blow the money, it's gone.  This is the single largest argument against commuting a pension.  In all honesty, some people are just not equipped to managed their life savings, and doing so would be a mistake even if the math suggests is would be a good idea.  After all, math is rules and equations, it's purely logical; but if we succumb to our emotions then good financial planning can be eradicated in a moment.

What about a DCPP?

If you've had a DCPP then you've already been responsible for the investment decisions, and ultimately the income derived from the portfolio.  It is still amazing to me how many people blindly invest their DCPP in a default portfolio without any consideration for the future.  I've seen people choose the most aggressive portfolio "because I'm young-ish," the most conservative because "I don't want to loose money," and a balanced portfolio "because I didn't know what else to do."  However, regardless of what you've done up to this point, now it's time to retire and you'll have to make some decisions going forward.  

How you handle a DCPP at retirement is approximately the reverse of a DBPP above.  Whereas the DBPP default is a lifetime income, the DCPP default is a lump sum.  If you want to turn it into a lifetime income, you can.  You have the option to purchase an annuity from an insurance company, which would provide you with a guaranteed lifetime income.  You could also choose several other types of investments with varying availability of guarantees, and varying risk profiles.  This is a critical time to engage a competent financial planner if you're not already using one (and it's a good time for a second opinion in any case).  


If you knew when you would die, this decision would be easy.
The biggest risk to retirees and their pensions is longevity - literally, living too long.  A lot of this risk is eliminated by having guaranteed incomes for life, especially if they are indexed to inflation.  So should you take the risk of commuting your pension to access the benefits of a lump sum?  It's an intensely personal decision and should be based on a solid financial plan for the future, as well as your own personality and investing acumen.  The gravity of this decision cannot be understated, it may be the most important financial decision of your life, do not move forward with a decision until you are sure you have been well informed.