Pension plans: Know your options

Most employees who are members of a pension plan have to make some decision when their job ends.   The process is easier once you understand the options and resources available.

The following summarizes the two main types of pension plans:

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 employees bear the risk of pension fund performance, so we encourage individuals to take advantage of any pension matching the one your employer may offer.

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 employer bears the risk of pension fund performance.  The employee is able to calculate their benefit with more certainty then a defined contribution plan.

Those with a defined benefit plan know their monthly payment amount, which provides some 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.

For defined benefit plans, the intent of the lump sum is to give the employee what is known as 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.

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 decision relating to your pension should be discussed with your accountant.

  • Are their 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?

Estate Planning

Those interested in leaving an estate may feel the lump sum offers more advantages.

  • 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?

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.

  • How close are you to retirement?
  • Are you in good or poor health?
  • Are you likely to get full value from a monthly pension?

Spending the time to think about the above issues will allow you to have a more productive discussion with your professional advisor prior to making any decisions.  The choice people make with respect to their pension is one of the many important financial decisions in the transition to retirement.