This is a common question we are asked on a regular basis in a world that is continually getting more complex and online especially as people approach retirement. Hopefully sooner rather than later in their financial planning discussions.
When you leave an employer, one of the biggest financial decisions you may face is what to do with your pension. For many employees and executives, the pension represents years of savings and future income security. But when offered the option to take the value of the pension today, it can feel overwhelming to decide whether to leave it where it is or transfer it out. Let’s walk through the key considerations so you can make an informed choice.
What is a pension plan?
A pension is a retirement savings arrangement set up by your employer.
There are two main types: defined contribution and defined benefit. With a defined contribution plan, both you and your employer contribute money, and the balance depends on investment performance. With a defined benefit plan, your future income is pre-determined based on things like your years of service and average salary. Many Canadians leaving an employer with a defined benefit plan will be faced with the decision of whether to keep the pension or commute (cash out) its value.
Defined benefit pensions are attractive because they provide predictable lifetime income. This predictability can give peace of mind. On the other hand, defined contribution plans shift the investment risk to you, since your eventual income depends on how the funds grow over time.
Your pension options
When you leave your employer, your options depend on the type of plan. With a defined contribution plan, you’ll typically move the money into your own locked-in retirement account or buy an annuity that provides income for life.
With a defined benefit plan, you can either:
- Leave the pension with your former employer, collecting a guaranteed monthly payment at retirement.
- Take the commuted value (the lump sum representing the present value of future payments) and transfer it to a locked-in retirement account.
Both options have trade-offs. Leaving the pension may give you peace of mind with guaranteed income for life. Commuting gives you control over the investments but shifts the risk to you. The decision also has implications for your family. Unlike a commuted pension, which can be passed on to heirs, most defined benefit pensions end upon death, except for survivor benefits that may be included.
Key considerations
This decision is highly personal and depends on several factors:
- Longevity: If you expect to live longer than average, staying in the pension may make sense because it ensures you don’t outlive your money.
- Stability of the employer’s plan: Some pensions are well-funded, while others face challenges. If you have doubts about whether the company will remain strong enough to pay pensions in the future, taking the commuted value may provide more security.
- Need for predictable income: A pension offers steady, reliable payments. If you’d feel more comfortable knowing exactly what you’ll receive each month, this could be valuable.
- Market risk: If you commute your pension, your retirement income will depend on market returns. That could mean growth, but also the possibility of running out of money if markets perform poorly or if withdrawals are too high.
- Estate planning: Pensions typically stop at death (with limited survivor benefits). If leaving money to your heirs is important, a commuted pension gives more flexibility.
It’s important to weigh these factors against your lifestyle, your other sources of income (such as CPP, OAS, RRSPs, or TFSAs), and your comfort with risk.
How much can you transfer?
When you choose to take the commuted value, the Income Tax Act sets a maximum amount that can be transferred tax-deferred into a locked-in retirement account (LIRA). The formula depends on your annual pension amount and a factor based on your age. Anything above this maximum must be taken as taxable income in the year you leave your employer. This can create a significant tax bill. Planning ahead with strategies like using RRSP room or your spouse’s RRSP can help soften the tax hit. In some cases, contributing to a TFSA may also be beneficial.
Unlocking pension money
Funds in a LIRA remain locked until retirement, but there are exceptions.
Depending on your province, you may be able to unlock money earlier if you face financial hardship, move out of the country, or have a shortened life expectancy. At retirement age, a LIRA typically converts into a Life Income Fund (LIF), which provides a stream of income but still follows government rules for minimum and maximum withdrawals.
Some provinces allow partial unlocking of a LIRA once you reach a certain age, which can improve flexibility.
Additional factors
There are also tax and income-splitting considerations. Pension income can often be split with a spouse, reducing household taxes. However, this benefit works differently depending on whether you keep the pension or commute it. If you keep your pension, income splitting is available immediately when payments begin. If you commute and move the funds into a LIF or RRIF, income splitting usually becomes available only at age 65.
Indexing and bridge benefits are also worth reviewing. Some pensions offer cost-of-living increases or bridge payments until government benefits like CPP or OAS begin. These can significantly impact the overall value of staying in the pension.
The bottomline
Deciding what to do with your pension when leaving an employer is one of the most important retirement choices you’ll face. Keeping the pension can give you guaranteed income for life; while commuting it offers flexibility and control, but with added risks and potential tax costs. The right decision depends on your personal goals, health, family needs, and comfort with investment risk.
If you’re unsure, take the time to speak to a Financial Life Planner before making your decision. A pension may be one of your largest assets, and the choice you make could shape your retirement for decades. Therefore, it is paramount to make an informed decision in Keeping Life Current.
