When planning for retirement in Canada, one decision many face is whether to commute their pension. Commuting a pension means taking the present value of your future pension payments as a lump sum rather than receiving monthly payments for life. While this may seem appealing to some, it’s important to understand the different types of pensions, and the pros and cons of doing so.
Types of Pension Plans in Canada
There are two main types of workplace pension plans in Canada:
- Defined Benefit (DB) Pension Plans: These plans promise a specific monthly payment for life after retirement, calculated based on factors like years of service, salary, and age. The employer bears the investment risk, ensuring the promised payout regardless of market performance.
- Defined Contribution (DC) Pension Plans: These plans are based on contributions made by you and, in most cases, your employer. The retirement income depends on the amount contributed and the investment performance of those contributions. In this case, you bear the investment risk.
Cons of Commuting a Pension
- Loss of Guaranteed Income: The biggest drawback is giving up the lifelong guaranteed income provided by a DB pension.
- Tax Implications: Every pension is different, but a portion of the commuted value can be taxable. If you have registered retirement savings plan (RRSP) contribution room, that could help reduce that taxable income. If it is not managed properly, this could result in a substantial tax bill.
- Inflation Risk: Monthly pension payments from DB plans can be indexed to inflation, ensuring your purchasing power remains intact. A commuted pension may not have this built-in protection unless you invest in inflation-protected assets. That being said, most investments can generate a higher return than just inflation.
- Complexity: Managing a lump sum requires ongoing attention, expertise, and professional advice. Not everyone is comfortable or experienced with long-term financial management.
Pros of Commuting a Pension
- Flexibility in Managing Funds: Commuting allows you to take control of your money. You can invest it as you see fit, providing flexibility in how and when you use your retirement funds.
- Flexibility in Tax Management: Commuting allows you to manage your tax situation by choosing what account to withdraw funds from. This will allow you to stay under the OAS Clawback level and ensure you are paying the least amount of taxes as possible while still maintaining your lifestyle.
- Estate Planning Benefits: A commuted pension becomes part of your estate upon death. If you pass away early, your heirs can inherit the remaining funds. With a traditional DB pension, payments often end at your death or are significantly reduced for a surviving spouse.
- Potential for Higher Returns: If you’re a savvy investor or work with a trusted financial advisor, you might earn returns that exceed the income you would have received through monthly pension payments.
- Geographic Independence: If you plan to retire abroad, commuting your pension eliminates concerns about currency fluctuations or restrictions on pension payments to other countries.
Factors to Consider
- Health and Longevity: If you have a shorter life expectancy or health concerns, commuting might make sense. Conversely, if you expect to live a long life, the guaranteed income from a pension could be more advantageous.
- Spending Needs: Assess your retirement lifestyle and whether the monthly pension income will cover your expenses. If you need more liquidity for early retirement goals, or flexibility to change your income over different years, commuting could provide that.
- Tax Planning: Work with a financial advisor to explore strategies for minimizing the tax impact of commuting a pension. For example, you might spread out taxable withdrawals over several years.
Last word
Commuting a pension is a significant decision that should not be taken lightly. It’s essential to weigh the pros and cons carefully and consider factors like your financial goals, health, tax implications, and risk tolerance. Working with a financial advisor can help you navigate the complexities of this choice and ensure it aligns with your overall retirement plan. Whether you choose to commute your pension or stick with the guaranteed income, the key is to be informed and make a decision that supports your long-term financial well-being.
This information has been prepared by Jai Gandhi who is a Investment Advisor for iA Private Wealth Inc. and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this post comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors.
