Should James take a lump-sum pension buyout and invest the money himself?

Q. I work for the provincial government of one of the Atlantic provinces. I will be 55 next year and will have 29 years of service; I’m ready to retire.

Since I am a fairly experienced investor, instead of waiting for employee pension payments to kick in, I am considering taking the commuted buyout and investing it so as to get a monthly payment each month from my self-directed investments. Is this a good idea or should I work another three years and just take my full company pension—paid monthly for life—at that time? And what are the pros and cons of both options?
–James

A. I’ll review what a commuted pension is, the pros and cons, as well as give you some things to think about.

The layman’s definition of a commuted pension is that it represents the lump sum amount of money needed to provide an income stream for life. For example, an ongoing income of $40,000 per year may require a lump sum of $607,000.

Following on with that example, let’s look at it from the other perspective: If you commute your pension, you’re giving up a guaranteed income for life of $40,000 per year to receive $607,000 upfront.

The majority of the $607,000 will be transferred into a locked-in retirement account (LIRA) and the remaining amount will be taxable to you. Ideally, your employer will let you know the taxable amount, but you use the table below if you want to do a rough estimate yourself.

PRESENT VALUE FACTORS TO AGE 71

To use the table, select your age at retirement—55, in your case, James—and multiply the present value factor by your annual pension income (10.4 x $40,000 = $416,000). The result, $416,000, is the lump-sum that will transfer to your LIRA; the remaining $191,000 ($607,000 – $416,000) is taxable to you, which will result in a lot of tax.

If you have $191,000 of RRSP* contribution room, you can transfer that amount to your RRSP which allows you to defer the tax and possibly reduce the tax owing (due to your income being lower in retirement, and subject to a lower tax rate, than your current income).

Now you have $416,000 in a LIRA, and if you’re lucky to have the contribution room, $191,000 in an RRSP. Both accounts are taxable when you draw money from them, but you are restricted to a maximum withdrawal from a Life Income Fund (LIF). Note that a LIRA is converted to a LIF when you want to draw an income. Check with your province to see the maximum you’re permitted to draw from a LIF each year. In Newfoundland the maximum withdrawal at age 55 is 6.5% of the total value, gradually increasing to 12.8% at age 80.

There are also some other things to consider are:

1. Shortened life expectancy. If you have a health issue it may make sense to commute the pension and leave a lump sum to your partner, but check the survivor benefits of your pension first.

If you no longer have a partner but will be leaving money to your children, there is a much stronger case to commute your pension as there are no survivor benefits for children. However, pension plans guarantee you a payment for a fixed period of time, often 10 years. If you pass away in the first five years of receiving your pension income your beneficiaries will receive a lump-sum payment equal to the present value of the remaining five years. A commuted value will provide a larger lump sum value if you pass away within the guaranteed period.

2. Can you invest better? Do you really think you can beat the pension fund managers returns over the long term? My suggestion: Don’t commute your pension for this reason alone.

3. Indexation and benefits. Your pension is likely indexed for life, so the payments keep up with inflation. Will you be able to make up the indexing through your investing returns? Also, check to see if your pension provides you with a health and life insurance plan. Some pensions do, and if you commute you will lose those benefits.

4. Your financial stability as well as the company’s stability. A pension pays a steady income just like a paycheque, and there is comfort in that. Do you really want to worry about the markets when you are retired? Also, pensions are guaranteed by the company or government holding the plan. What is the risk of the company, or province in your case, not being able to fund their pension responsibilities? (Sears Canada is a recent example of a company that reduced retirees’ pension payments due to financial troubles.)

5. Pension splitting. With a pension plan, you can split pension income as soon as the pension starts. With a LIF or RRIF, you have to wait until age 65 before you can split pension income with your partner.

6. Unlocking provision. Some provinces allow you to unlock some of your LIF—and Saskatchewan allows you to unlock it all. In Newfoundland you can’t unlock any amount of your LIF, so you may find in certain years the amount you can draw from your LIF is less than what your pension would have provided. The taxable amount should make up the difference, assuming you don’t spend it right away.

The real con of commuting your pension is: What if it doesn’t work out as planned? About 15 years ago I was approached by a person who, along with three others, could commute their pensions, which were valued at about $1,000,000 each; or work three more years and receive a full pension—so, very similar to your situation. He ended up working three more years, while the other three people decided to commute their pensions. Guess which one didn’t have to return to work? All three who commuted had to return to work for various investment reasons.

My final thoughts are to get your numbers and go to a financial planner so they can run a comparison of commuting versus not commuting. Keep in mind that most financial planners are compensated for providing advice that brings money into the firm or institution they work for, so they may be biased toward commuting the pension.

James, unless you have a compelling reason for commuting your pension, keep it. If you want to invest on your own, open an investment account and risk an extra week’s vacation, rather than your whole retirement.

Allan Norman is a Certified Financial Planner with Atlantis Financial Inc. and can be reached at [email protected]

Allan Norman is licensed for the sale of insurance products and provides financial planning services through Atlantis Financial Inc. Additionally, he is an IIROC registered investment advisor with Aligned Capital Partners Inc. (ACPI), and as such, if you contact Allan you may be dealing with more than one entity depending on the products or services discussed. Any reference to specific mutual fund companies should not be regarded as an endorsement, offer or solicitation to buy or sell any investment fund or service. Mutual funds are provided by Aligned Capital Partners Inc. (“ACPI”).

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