The article “Here’s What You Need To Consider Before Taking An Early Retirement Package” was original published on Financial Post on June 11, 2020.
Four key things to think about before and after signing on the dotted line
The pandemic lockdown and resulting recession have led to a surge in voluntary severance offers for those approaching retirement. As employees contemplate their options, there are four key considerations before and after signing on the dotted line.
Accepting an early retirement will result in a voluntary severance payment. The payment is generally based on a pre-determined number of weeks of salary paid for each year of an employee’s service. For example, an employee may be entitled to four weeks per year of service with a minimum and maximum number of weeks of pay.
Severance paid due to a voluntary early retirement may be more generous than an employee might be entitled to if their position was terminated otherwise. An employment lawyer can advise as to what a reasonable entitlement might be for a specific employee and whether the severance terms are appealing.
A severance may be paid in a lump sum or as a salary continuance over time. A significant lump sum payment may cause an employee to pay a significant amount of income tax when added to their other income for the year. Sometimes there may be an option to defer the severance or a portion thereof to a future tax year, or have payments made over several years. This may result in less tax payable.
An employee who receives a lump sum payment may have only 30 per cent tax withheld, as this is the required withholding rate for payments over $15,000. Given that top tax rates in several provinces exceed 50 per cent, a recipient should budget for the incremental tax payable and consider tax reduction options such as RRSP contributions.
Salary continuance, whereby a salary continues to be paid regularly over the duration of the severance period, can also result in tax minimization. Salary continuance may enable ongoing pension contributions to increase a future pension.
LOSS OF BENEFITS
Salary continuance can also allow an employee to be covered by an employer’s group insurance benefits during the payment period. Regardless, the end of employment will generally result in the end of an employee’s benefits coverage at some point, unless there is a retiree plan offered.
This is often a concern for potential retirees. Private health insurance policies are an option but so is self-insuring. A health plan is great for employees because the cost is spread amongst several plan members and employers may cover some or all of the cost. Invariably, some members will use the plan sparingly, and others will come out ahead.
When you are a member of a private plan and paying your own premiums, you may be less likely to receive more reimbursements from the insurer than you are paying into the plan. Insurance, by its very nature, requires more premiums to be paid into the plan than are paid out. This, coupled with the maximum annual coverage limits, may cause some retirees to consider simply paying for their health-care costs themselves and forgoing coverage. There is also government coverage for seniors for prescription drugs that varies by province.
COMPANY PENSION AND SAVINGS PLANS
Employees who have a pension plan at work may have a significant decision to make upon leaving their employer.
Defined benefit (DB) pension plans pay a monthly benefit to a pensioner. Payments can generally begin between age 55 and 65. Beyond choosing when to start a pension, there may be payment options as well. These options could include survivor options for a spouse upon a pensioner’s death, a guarantee period for payments if a pensioner dies at a young age, or other potential elections.
The higher the guarantee period or percentage of a pension that is payable to a surviving spouse, the lower the monthly pension payments to the recipient. Some reasons to consider higher guarantees and survivor options are a pensioner having a shortened life expectancy, a younger spouse, or a spouse without a pension of their own.
Some retirees may be able to elect to take a lump sum commuted-value payment to forgo their future DB pension payments. Some or all of this payment will be eligible for a tax deferred transfer to a locked-in retirement account, but some may be subject to taxation in their year of the payment.
Commuted value payouts are not available to all pensioners, and the decision to forgo a guaranteed monthly pension can be a substantial one. Some reasons to consider a commuted value are having a shortened life expectancy, having another DB pension plan, having a spouse with a DB pension plan, or having a high investment risk tolerance.
Employees with defined contribution (DC) pension plans may be able to transfer their plan to a locked in retirement account at another financial institution or leave the plan in place with the current provider. Fees for retiree investment options may be competitive compared to external options.
For those who are ready to retire, one challenge is determining the timing of pensions. In addition to DB and DC pensions that can be started immediately or delayed, there are government pension options to consider as well.
A retiree who is 60 or older has the option of beginning one or both federal government pension plans. Canada Pension Plan (CPP) retirement pension can start as early as age 60 or as late as age 70. Old Age Security (OAS) can start as early as 65 or as late as age 70. The later a recipient begins their pension, the higher the monthly payments.
Both pensions have nuances. CPP, for example, has a survivor benefit potentially payable to a spouse. OAS has a clawback or repayment of benefits if a recipient’s income exceeds $79,054 in 2020.
For those who are not sure if they can afford to retire, it can make a voluntary severance package that much riskier. Despite the attractive terms, if an employee is not yet financially independent, or unable to easily replace their income while they continue to work, an early retirement may risk a reduction in their retirement lifestyle. Retirement planning should include a thorough assessment of all retirement income sources and expenses, as well as any remaining debt or planned asset sales, like home downsizing plans.
The psychological and emotional impact of retirement should also be considered. Whether someone likes their job or not, retirement may result in a loss of purpose or friendships, and some retirees will find it easier than others to fill forty hours a week with other things. The non-financial aspects of retirement planning may be almost as important as the financial considerations.
There are several factors to be considered before accepting an early retirement package and upon retiring. The severance terms, the loss of benefits, the pension options, and retirement planning are just some of them. It may be a fantastic opportunity for some employees, while for others, there can be risks.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.