The article “Pension Withdrawals: Lump-Sum vs. Deferred Payment” was originally published on MoneySense on March 24, 2015.
Bill is trying to make a choice between taking a lump-sum commuted value from his defined benefit pension or simply taking a monthly payment
Q: I am about to make a decision on whether to take a lump-sum on my pension or a monthly amount. I have some other investments, but my thought was I did not want everything tied up in the markets in case markets took a dip. I thought a monthly amount might be best for my situation, but I may be wrong.—Bill
A: The biggest retirement decision that an employee can make is when to retire. The second biggest is what to do with their defined-benefit pension, if they have one.
Sometimes, the pension decision comes about because of retirement. In other cases, it’s due to a termination of employment or a company making a change to their pension plan for employees. Regardless, it’s not uncommon to be given a choice between taking a lump-sum payment in lieu of your future monthly pension (known as a commuted value) or otherwise taking your calculated monthly pension payment in retirement.
If you take a lump-sum, Bill, it can typically be transferred to a locked-in retirement account (LIRA), which is just like a regular RRSP with a few restrictions. The restrictions relate to how soon withdrawals can begin (generally age 55) and the amount of your annual withdrawals (maximum amounts based on your age). Depending on the specifics of your pension, part of the lump-sum may not be able to go into an RRSP and may be taxable to you in the year of receipt.
There are a few considerations before making your decision between the two choices, Bill. In particular:
-Investment risk tolerance;
-The value of the pension relative to your other assets;
-The stability of your employer
Retirement planning would be a much easier exercise if we just knew how long we’d live. A defined-benefit pension ends up being kind of like a life insurance policy, but in reverse. It protects you from the risk of living too long. So if you think you’re likely to have a longer than average life expectancy, Bill, a monthly pension could be a good choice because it lives as long as you do.
Investment risk tolerance is a very important consideration as well, Bill. If you’re a conservative investor who might otherwise invest your pension proceeds in conservative investments, you might have a hard time “beating” the option of a monthly pension payment in the future and creating a higher potential monthly income with your investments. A higher risk tolerance and theoretically higher rate of return should cause you to lean more towards a lump-sum.
Your dependents should also impact your pension decision. Monthly pensions can typically include survivor benefits that continue to pay out to your survivor or survivors on your death. But usually, it’s just a percentage and may only be payable to a spouse. Commuted values in your RRSP can be willed however you’d like to your beneficiaries.
You may also want to consider your pension value relative to your other assets. If you have significant investments already, choosing a deferred monthly pension may help “diversify” your retirement income.
Your employer’s stability is important as well. Opting for a monthly pension means you’re putting faith in your employer’s ability to pay you for potentially decades to come. If you work for a small company, a speculative company or you’re a senior executive with an unregistered pension, a lump-sum has a certain bird-in-the-hand appeal that should be considered.
Currently, a strong incentive to consider taking a lump-sum from your pension is low interest rates. The calculation of commuted values has an inverse relationship with interest rates. So the lower rates are when you take a lump-sum, the higher the payment will be.
I wouldn’t be too worried about “markets taking a dip”, Bill. If you’re concerned, take the lump-sum in cash and invest it slowly into the markets within your locked-in retirement account. Whether stock markets are likely to go up or down this year should be a small determinant of your pension decision, given 2015 stock market performance will likely be but a blip in the returns that will come from stock markets over the balance of your life.
When making a decision between a lump-sum and a monthly pension, consider some of the soft facts above. But crunch the numbers on the hard facts in your own personal situation as well. A retirement plan that looks at the two options can help provide a relative comparison.
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.