More Canadians Should Take the Commuted Value of Their Defined Benefit Pension.
When you leave an employer after contributing to a Defined Benefit (DB) pension plan, whether it’s early in your career or at retirement, you’re faced with a crucial financial decision: do you take the commuted value of your pension, or do you leave your retirement savings in the defined benefit plan? Defined Benefit pensions are often considered a stable retirement foundation, but in many cases, taking the commuted value—a one-time payout based on the present value of your expected pension income—can be the smarter choice for Canadians.
In this blog, we’ll explore why, for many Canadians, the commuted value option is a more advantageous decision. We’ll look at the factors that influence this choice, including expected investment returns, survivor benefits, inheritance potential, and the flexibility it provides, so that you can make the best choice for your financial future.
What Is a Defined Benefit Pension?
A Defined Benefit pension plan provides you with a guaranteed income upon retirement, calculated based on factors like your salary and years of service. The stability and predictability of these pensions make them attractive, especially as retirement income has become more uncertain over time. However, this certainty comes with a cost that many are not aware of.
When you leave your employer, you have the choice to take a lump-sum payment—known as the commuted value—of your pension’s value today. This option allows you to invest your pension savings independently, potentially earning a higher return and adding more flexibility to your retirement plan.
Why Taking the Commuted Value Is Often the Better Option
Let’s dive into the main reasons why taking the commuted value of your Defined Benefit pension may be the smarter option for your retirement planning.
1. Higher Investment Returns Over Time
One of the biggest drawbacks of leaving your pension in a Defined Benefit plan is the conservative approach these pensions typically take to calculating your future income. When determining the commuted value of your pension, the pension fund uses a rate of return based on a risk-free interest rate—often a long-term bond yield, which could be around 4% or less.
This conservative return is far below what you might expect if you invested the commuted value in a growth or balanced portfolio. By investing prudently with the help of a professional, you could potentially earn a higher annual return, which could significantly increase your retirement savings over the long term. For instance, a well-diversified portfolio with a moderate risk profile has historically returned around 6-8% annually. Over a 20- or 30-year period, this difference in returns could translate to a significantly larger retirement fund.
Imagine you’re 40 years old and have just been restructured out of your job. For the past decade, you’ve been contributing to your employer’s defined benefit pension plan, and now you’re given the option to take the commuted value of your pension, which has been calculated at $100,000. This amount represents the present value of your future pension income, which uses a 4% return to discount the future income back to today’s value.
In straightforward terms, if you take that $100,000 and invest it to earn a return higher than 4%, you’re likely to come out ahead compared to sticking with the pension option. With a time horizon of 20 to 25 years until retirement, the chances of achieving returns above this 4% threshold are very high, making the commuted value option a compelling choice.
2. Survivor Benefits and Inheritance Potential
Defined Benefit pensions typically offer limited survivor benefits. In most cases, if you pass away, your spouse may receive a reduced benefit, but if you’re not married, the pension may end entirely. Even with a spouse, the payout usually reduces, and after both spouses pass away, the remaining pension benefits cease. Effectively pension regulations have allowed for plans to be designed in a way that they are more valuable in the hands of Canadian’s who have a spouse.
This setup can create a situation where, after contributing to a pension for 30 or 40 years, you could end up leaving little to nothing behind for your loved ones. If you instead take the commuted value and invest it, you have full control over your assets. This means that, even if you pass away prematurely, the value of your investments can be passed on to your beneficiaries. You retain the flexibility to leave a legacy, whether that means supporting your children, donating to charity, or preserving family wealth.
3. Flexibility and Control Over Your Retirement Income
Taking the commuted value provides a great deal of flexibility when it comes to managing your retirement income. With a Defined Benefit pension, the payout is fixed based on formulas defined by the plan, giving you little control over how much you receive and when. While this fixed income can be valuable, it may not meet your changing needs throughout retirement.
By investing the commuted value, you can work with an advisor to create a personalized withdrawal strategy that adjusts to your spending needs. For instance, if you want to travel more in the early years of retirement or cover medical expenses, you can adjust withdrawals accordingly. This flexibility can significantly improve the quality of your retirement, allowing you to live on your terms.
4. Potential Tax Advantages
Taking the commuted value and investing it yourself can also provide tax planning opportunities that Defined Benefit pensions don’t. By moving a portion of the commuted value to a Locked-In Retirement Account (LIRA) or other retirement vehicles, you may defer taxes on a large part of your pension. This option allows you to manage your withdrawals in a tax-efficient way, potentially minimizing taxes on your retirement income compared to a traditional Defined Benefit pension payout.
Why Canadians Default to Defined Benefit Pensions
Many Canadians simply leave their retirement savings in Defined Benefit pensions when they leave an employer, often out of a belief that it’s the “safer” or “easier” option. The cultural belief in Canada has long been that Defined Benefit pensions are the “gold standard” of retirement, guaranteeing stability and income security.
However, it’s important to recognize that this perspective doesn’t account for the limitations of these pensions in terms of growth, inheritance, and flexibility. Defined Benefit pensions may be reliable, but they are often restrictive, preventing Canadians from accessing the full potential of their retirement savings.
Key Considerations Before Taking the Commuted Value
While taking the commuted value offers many advantages, it’s essential to consider the risks and make an informed decision:
1. Investment Risk: When you take the commuted value, you assume the responsibility of investing and managing these funds. This means your retirement savings will be exposed to market volatility, and your portfolio could experience fluctuations based on market conditions. Working with a qualified financial advisor is crucial to managing these risks and maximizing your portfolio’s growth.
2. Self-Discipline in Spending: With a Defined Benefit pension, you receive regular payments, which enforces a degree of budgeting. If you take the commuted value, you’ll need to be disciplined in managing withdrawals to ensure your funds last throughout retirement. Financial planning is key to maintaining a sustainable withdrawal rate.
3. Professional Financial Advice: Many Canadians could benefit from working with a financial advisor to navigate this decision and create a comprehensive retirement plan. An advisor can help assess your risk tolerance, build an investment portfolio aligned with your goals, and develop a tax-efficient withdrawal strategy.
Ready to Explore Your Pension Options?
If you’re at a crossroads—whether you’re facing retirement or have recently left a job—this decision requires careful thought. Understanding the implications of your choice between leaving your pension as is or taking the commuted value can have a profound impact on your retirement and your financial legacy.
Too many Canadians default to the Defined Benefit pension option without fully considering the alternatives. Taking the commuted value and investing it can provide growth, flexibility, and security that a traditional pension often cannot.
Reach out today if you’d like a deeper dive into these options. We can discuss your unique situation and help you determine the best approach for a retirement plan that works for you, not just today but for years to come.
