Retiring employees and those who change careers or are displaced for various reasons are often faced with some difficult decisions, because how they deal with pension plans can have consequences for their retirement
Decisions can be easier if people understand their options clearly and the resources available. Some may not have a choice with respect to their pension. But for others the confusion begins when you’re given various options. Many companies offer employees a choice between taking their pension in the form of a monthly payment or a single lump sum payment. The following summarizes the two main types of pension plans – defined contribution plan and defined benefit plan (also known as money purchase).
Defined Contribution Plan
The contributions into this type of pension plan are established by formula or contract. Many defined contribution plans require the employer and/or employee to contribute a percentage of an employee’s salary each month into the pension fund. The employer does not make a promise with respect to the amount of retirement benefits. The key point to take away is that the employee bears the risk of pension fund performance in a defined contribution plan. We encourage individuals to take advantage of any pension matching your employer may offer. With this type of plan employees are generally given a choice amongst different types of investments (i.e. conservative, balanced, aggressive).
Defined Benefit Plan
With a defined benefit plan, the employer is committed to providing a specified retirement benefit. The benefit is established by a formula, which normally takes into account the employee’s years of service, average salary and some percentage amount (usually between one to two per cent). The key point to take away is that the employer bears the risk of pension fund performance. Another key point is that the employee is able to calculate their benefit with more certainty then a defined contribution plan.
Those with a defined benefit plan know with more certainty what their monthly payment amount will be, providing benefits for financial planning. The end benefit is less known for people with defined contribution plans. A key question to ask yourself: “Is the pension your primary asset or main source to fund retirement?” If the answer is yes, then we would encourage most people to take the monthly pension. If your pension is not your primarily asset or you have multiple sources of income then leaving the fund and receiving a lump-sum may make sense.
Choosing this option means that the monthly pension is forfeited. For defined benefit plans, the intent of the lump sum option is to give the employee what is known as the present value (or commuted value) of the monthly pension amounts that would otherwise be received. The calculation, which is usually made by an actuary, makes assumptions about life expectancy and inflation and uses a discount factor to determine what the lump sum equivalent should be. The lump sum amount is meant to represent the effect of receiving a lifetime worth of pension payments (from retirement to death) all at once. It is important to note that individuals that leave the pension and receive a lump sum, may purchase an annuity with some or all of these funds.
Helping You Decide
The following are some factors to consider when deciding whether to stay with the pension, purchase an annuity or take the lump sum.
Retirement Planning: Determining what you would like from your retirement may assist you in making the decision.
- Is the pension your primary asset?
- Would you lose sleep worrying about managing a lump sum?
- Will the fixed monthly amount cover your monthly cash flow needs?
- Are you concerned about outliving your savings?
- Do you like the idea of managing your finances at retirement?
- What other sources of income do you have to fund your retirement?
Investments: Some people may want the freedom to choose their own investments while others may choose the hands off approach.
- How are the funds currently being managed?
- If you chose the lump sum would you manage the funds yourself or obtain assistance from a financial advisor?
- How much risk are you willing to take with your investments?
Pension Benefits: Many employers provide individuals that choose to stay with the pension a few other benefits that should be factored in.
- Do you have a defined benefit plan or a defined contribution plan?
- How long have you been a member of the pension plan and how is the pension formula calculated?
- Is the monthly pension indexed?
- Does the monthly pension option provide medical, dental or life insurance coverage?
Tax Consequences: Major decisions relating to your pension should be discussed with your accountant.
- Are there any immediate tax consequences?
- Are any retiring allowances transferable to your RPP or RRSP?
- How will the choice of options affect future income taxes?
- Is it possible to split any income? (Note: the Federal Finance Minister’s “Tax Fairness Plan” announced on October 31, 2006 outlines what income is eligible to be split)
- Are you single, married or living common-law?
- Does your pension provide a benefit to your surviving spouse (if applicable)?
- Is leaving an estate important to you?
- How close are you to retirement?
- Are you in good or poor health?
- Are you likely to get full value from a monthly pension?
Estate Planning: Individuals interested in leaving an estate may feel the lump sum offers more advantages.
Life Expectancy: This is perhaps the most important component to the decision making process. Most people normally begin the decision process by doing a few calculations. With every calculation people would have to make assumptions with respect to life expectancy. If you were to live to an old age, significant value may be obtained by leaving your funds in a defined benefit plan or by purchasing an annuity with lump sum proceeds.
Spending the time to think about the above issues will allow you to have a more productive discussion with your professional advisors prior to making any decisions. The choice people make with respect to their pension is one of the most important financial decisions they need to make.