Should You Take The Commuted Value Of A Pension?
Fee-for-service financial planner and founder of PlanEasy.ca
Defined benefit pensions are often an enormous advantage when it comes to retirement planning but there are also some very complex decisions that need to be made. One of those decisions could be whether or not you should take the commuted value of a pension.
The commuted value represents the lump-sum value of a defined benefit pension… it is the amount that the actuary feels your pension is worth in today’s dollars… and it can be very very large.
A reasonable defined benefit pension could have a commuted value worth $250,000+, or $500,000+, or even $1,000,000+
Seeing all those zeros can be very enticing. This can cause many people to consider taking the commuted value rather than the lifetime retirement benefit offered by a defined benefit pension.
But should you take the commuted value of a pension? There are often many things to consider when deciding to take the commuted value of a pension and the size of the commuted value itself is one just one piece of the puzzle.
Let’s take a look at a few of the factors that you may want to consider, but first, what is a commuted value exactly?
What Is A Commuted Value?
A commuted value (sometimes referred to as CV) is essentially a lump sum which you could receive instead of a monthly pension payment. This lump sum is roughly equal the amount of your future pension payments.
The exact amount of your commuted value will depend on the actuarial assumptions used. Pension actuaries will make this calculation based on a number of factors like rates of return, interest rates, longevity assumptions etc.
One very important factor is the interest rate assumption. This assumption can have a large impact on the size of your commuted value. In a low interest rate environment this interest rate assumption can lead to some very large commuted values.
But just because the commuted value is large doesn’t necessarily mean you’ll receive the full amount in your pocket. Taxes are an important consideration when deciding to take a commuted value.
Taxes aren’t the only consideration either. There are other factors that need to be considered. Every situation is different and it is important to look into a few specific factors to help decide.
Income Tax and Maximum Transfer Value (MTV)
When commuting a pension there is a calculation that is done to determine how much of the total commuted value can be placed inside a registered account like a LIRA or a LIF. This is called the Maximum Transfer Value (MTV).
The MTV is based on your lifetime retirement benefit per year and your age. Notice that it does not take into account other benefits like bridge benefits, indexation benefits, supplemental executive pensions etc, all which would be included in your commuted value.
The MTV will not be subject to income tax because it’s being placed inside a registered account, but everything above the MTV will get taxed at your marginal tax rate, and this can be significant.
It’s not uncommon for 25% to 50%+ of the commuted value to be taxed at your marginal tax rate. This can potentially mean thousands, if not hundreds of thousands of income tax to be paid. This is especially important for large commuted values which could be taxed at the highest marginal tax rate.
Some of this can be avoided with an RRSP contribution, if you have the room, but otherwise the after-tax value could be much lower than the commuted value number you see on your pension statement.
Income Splitting And Government Benefits
Another consideration when deciding whether or not to take the commuted value of a pension is that income from a defined benefit pension is eligible for income splitting before the age of 65. Income splitting can be very valuable for early retirees when managing income tax.
This income splitting isn’t really available when taking the commuted value (although there are some options). If income splitting helps avoid a large amount of income tax before age 65 this can be an important consideration and can make the lifetime retirement benefit more attractive.
On the other hand, for low-income retirees, payments from a defined benefit pension trigger extremely high clawbacks on GIS benefits. Like income tax, these clawbacks reduce the amount a retiree has available to spend and they can range between 50% and 75%! This makes a small monthly pension payment somewhat undesirable for some retirees who may be eligible for GIS.
In these cases, where a retiree might be eligible for GIS, it may be advantageous to take a commuted value because the retiree has more control over how this money can be used to create income in the future. Even though they may lose out on income splitting, they may gain by optimizing their GIS benefits.
Life Expectancy And Longevity Risk
One of the benefits of taking the commuted value of a pension is that its essentially “a bird in the hand”. This can be favorable when you are expecting a shorter than average life expectancy.
However, one of the major benefits of a defined benefit pension, especially one that is indexed to inflation, is that it provides a great deal of longevity protection. This can be very advantageous if you’re expecting a long and healthy retirement.
Those defined benefit pension payments will continue as long as you live (and if there are survivor benefits then they’ll continue as long as your spouse lives as well).
Because longevity risk is such a large risk in a financial plan (and it’s so difficult to manage) this is a major consideration when deciding whether or not to take the commuted value of a pension.
Health, Travel and Other Benefits
Regular pension payments are the main benefit of a defined benefit pension but they’re often not the only benefit.
Often there are other benefits that come with a defined benefit pension that are lost when taking the commuted value. For example health benefits and/or travel benefits may come with a defined benefit pension and would be lost if taking the commuted value.
These benefits can be very valuable in retirement and should be considered as well. Travel insurance and health insurance can be very costly in retirement, so make sure to understand these benefits before making a decision.
Investing A Commuted Value
The last and possibly most important consideration is how a commuted value will be invested. Investing a commuted value is necessary to ensure that it provides income over a long retirement period. Investing a commuted value comes with new risks like investment risk and behavioural risk.
One important consideration is that individuals with a defined benefit pension often have very little investment experience. Their annual pension contributions may have taken up much of their RRSP contribution room each year and/or they didn’t need to make additional savings or investments to achieve their retirement goals.
This means they may have very little savings and investments outside of their defined benefit pension.
This can make taking the commuted value a risky decision. With little or no investment experience it can be daunting to invest a sizable commuted value.
Individuals who do not have a defined benefit pension have (hopefully) learned over time how to manage a large investment portfolio. They’ve been through at least 1, 2, or 3+ recessions. They’ve had lots of practice making difficult investment decisions.
Without a lot of investment experience it can be difficult to make these decisions for the first time, especially when it involves a large sum of money, and especially when that money needs to support retirement spending for decades to come.
Financial planner, personal finance geek and founder of PlanEasy.