Individuals with a Defined Benefit Pension Plan (DBPP) are often faced with a tough decision when they leave their place of employment; whether to keep a portion of their pension plan or take the commuted value. The commuted value of your pension is a single lump sum payment that is, in theory, the value of your pension at the time that you take it. For example: the employee may have a choice between a $425,000 lump sum payment (commuted value) and an annual income of $35,000 in retirement (pension).
What You Need to Know
Commuted Value
Pro: Control
Taking the commuted value of your pension allows you to invest the money in a Locked-in Retirement Account (LIRA), which gives you full control over the investment decisions.
Pro: Growth Potential
Depending on how far away from retirement you are and on how well your investments are managed, taking the commuted value of the pension and investing it successfully may provide you with greater income potential than a fixed pension would
Con: No Guarantee
Taking the commuted value of a pension removes any guaranteed income stream since you’ve taken responsibility for the management of your pension money. In your hands, the money is exposed to a variety of risks, including investment and possibly inflation risk, both of which could compromise your retirement income.
Pro or Con? Accessibility
The accessibility aspect of taking the commuted value can be a mixed bag. For the self-disciplined investor, having this money accessible can provide the opportunity to occasionally take less or more income depending their on specific circumstances. However, on the other hand, accessibility could be a con since it could be tempting for some people to dip into their pension money to fund short term goals, thereby losing sight of the long-term purpose of the money.
Pension
Pro: Predictability
By keeping the pension, you can predict will know exactly how much money you will receive for the remainder of your life and this can bring about great peace of mind and make retirement planning a lot easier.
Pro: Simplicity
Keeping the pension takes the work out of maintaining an investment account and making investment decisions.
Con: No Residual Amount Leftover
While some pensions have a spousal benefit that is equal to a portion of your pension payments, keeping your pension means there is no money left over for your estate after your death. This means that once you die, if you were single or did not have a spousal benefit, your pension would cease.. If you do have a spousal benefit, the pension would cease on the death of your spouse.
Con: Solvency Issues
Companies need to be able to fund pension plans and a fully funded plan is said to have a 100% solvency ratio. Unfortunately, this is a rarity and the risk stands that your pension could be compromised in the event a company goes under.
The Bottom Line
Deciding between keeping a pension or its commuted value is an important decision that shouldn’t be taken lightly. A financial professional can help you understand your options and can explain the short and longer-term implications of both options