Taking a lump sum payment? What you need to consider first
Author: Maria Smith
When it comes to company pension plans, employees prefer defined benefit plans. But come retirement, or when you decide to leave the plan, you have a decision to make. Should you keep your money in the plan and receive future installment payments? Or should you take it out as a lump sum payment and invest it on your own?
What is a pension lump sum payment?
A pension lump sum payment, also known as a commuted value, or payout, is the future value of a defined benefit plan expressed as a dollar amount today. It's an estimate of how much money you will need today to provide income for life.
When does it make sense to take a lump sum payment?
- Ability to provide an inheritance – when you keep your money in a defined benefit retirement plan and you die, there may or may not be a survivor benefit for your spouse or common-law partner. But if you take out a lump sum payment, you have more flexibility in providing an inheritance to whomever you choose.
- Shortened life expectancy – if you have a shortened life expectancy, you may be able to get the most out of your plan by taking the commuted value. You are guaranteed a specific dollar amount for your retirement regardless of how long you live.
- Control over your investments – when you take out the lump sum payment, you now have control of that capital. You can choose how to invest or spend it.
- It's safer if the company's future is at risk – this isn't a considerable concern for most as currently, 71% of DB pensions are in the public sector. But if you are an employee in the private sector, it is worth considering because it could affect your future income if that company goes bankrupt.
When does it not make sense to take a lump sum payment?
- What if things don't work as planned? – it's great to take out a lump sum and think that you can invest better than a pension fund manager. But what if things don't go as planned? You could find yourself with a financial shortfall come retirement.
- Financial behaviour – if your behaviour with money has shown that you are a risk-taker or a spender, you may not have many investments left when it comes time to start needing them.
- Less certainty – keeping your cash in a defined benefit retirement plan guarantees you a steady income for life. When you commute your pension via a lump-sum payment, the eventual income may not be a sure thing.
- Loss of secondary benefits – some DB plans include health and life insurance benefits. But if you take the lump-sum payment, you may no longer be eligible for these employer benefits. And will therefore have to pay the cost of them yourself.
Like anything financial, there are tax implications to consider when deciding to take the commuted value of your pension or not.
If you decide to take a lump-sum payment, a portion of it goes into a LIRA (locked-in retirement account), and the rest would be available as cash. The federal and provincial governments legislate how much is available in cash and how much is locked in.
The portion available in cash immediately incurs a tax bill at your marginal tax rate. Unless you have RRSP room, if so, then you can transfer the "cash" into your RRSP to decrease the tax owing.
When you eventually withdraw from the LIRA or RRSP, those withdrawals are taxed at your marginal tax rate.
With a defined benefit plan, you can income split as soon as pension payments start. But with a LIRA or RRSP, income splitting between spouses or common-law partners cannot begin until 65.
Questions to help guide your decision
- What is your pension start date, amount, and is it indexed (provides inflation protection)?
- If you commute your pension:
- How much would be transferred into a LIRA?
- How much would be taxable?
- Can you split the cash out over two years to decrease the annual tax burden?
- How much RRSP room do you have?
- What is your projected life expectancy?
- What other retirement income sources do you have?
- Do you want to leave an inheritance?
- What other benefits does the employer plan include?
- What rate of return do you need to get on your commuted value to match your future pension income amount?
- Will future pension payments change with Canada Pension Plan payments? Old Age Security Payments?
As you can see, deciding to take a lump-sum payment or not is complicated. And will differ based on your financial situation.
This is not a decision you want to get wrong and not one you can go back on.
For this reason, if you have a defined benefit pension and are considering taking a lump sum payment, it may be worth your time and money to get some professional advice.