The pension decision
Maximize your benefit entitlement when you leave a job
Julie and Brad work full-time for two different companies in Toronto. Julie is a graphic designer for a lifestyle magazine, and her employer offers a defined contribution pension plan. Brad is a project manager for an engineering firm that provides a defined benefit pension plan. For several years, Julie and Brad have been thinking about relocating to New Brunswick to be closer to their parents – especially Julie’s mother, who recently moved into a nursing home.
Now, it looks like they can make this dream a reality. A few weeks ago, Brad received a job offer from another company in Moncton. Julie’s sister, a marketing consultant in Saint John, has offered to set Julie up with freelance work. The couple is preparing to sell their house, pack up their belongings and head back east.
But one thing worries them: When they leave their current jobs, what will happen to their pension plans?
To learn about their options, they make an appointment with their financial advisor, Chris. Chris takes a look at the terms of both pension plans and explains that, like many people who are leaving their current employers, Julie and Brad have an important decision to make. Either they can keep their pension entitlements on a paid-up basis with their former employer, or they can move the money into a personal locked-in RRSP or Locked-in Retirement Account (LIRA).
In Julie’s case, the decision is relatively easy. The full market value of her defined contribution entitlement can be transferred to a personal LIRA. The advantage of this, Chris says, is that it will provide her with full and direct access to a more diverse range of investment options – which are typically more limited in the company pension plan. The transfer of the “commuted value”1 to a LIRA isn’t as straightforward for Brad because he has a defined benefit pension plan. Chris outlines five considerations Brad needs to take into account to ensure that he makes the most of his entitlement.
1. MAXIMUM TRANSFER VALUE
In many cases, the maximum transfer value imposed by the Income Tax Act will prohibit the full value of a defined benefit entitlement from being transferred to a LIRA. Regulation 8517 provides a factor based on age that is multiplied by your annual benefit (see table). Because this factor does not take into account the value of additional benefits such as indexing or early retirement features, the maximum transfer value is often less than the true cost of the benefit provided. This creates a problem since a portion of the commuted value may not be transferable and must be taken into income as a lump-sum taxable amount. Brad can reduce the impact if he has available RRSP room and makes a regular contribution. However, many people in this situation do not have the necessary room since their RRSP contribution limits have been reduced each year by the value of the benefit received under the pension plan (known as a pension adjustment). Chris notes that a pension adjustment reversal (PAR) may be available under certain circumstances (see section 5 – Pension adjustment reversal below).
Chris walks Brad through a couple of scenarios to show him that, even with the maximum transfer value, moving his entitlement to a LIRA may make sense. Brad is 50 years old, and his pension statement indicates that the commuted value of his benefit is $350,000. His annual benefit is $27,000, payable at age 65 and indexed at two per cent each year thereafter.
If Brad transfers the commuted value to a personal LIRA, the maximum allowed as a direct transfer under the Income Tax Act will be $253,800 ($27,000 multiplied by the factor of 9.4). The balance of $96,200 will be paid to him as a taxable lump sum. At a 46 per cent tax rate, he would have an after-tax balance of $51,948. If Brad invests both these amounts for 15 years – the $253,800 in a LIRA and the after-tax lump sum of $51,948 – he will need a rate of return of 2.4 per cent compounded annually to have the $430,000 needed at age 65 to purchase the same $27,000 indexed pension income. Alternatively, if he decides to spend the $51,948 and invest the $253,800, he would need a compound rate of return of 3.7 per cent. Even in a low interest rate environment, this rate of return may be achievable. Nonetheless, Chris points out that in other situations the large tax bill may make transferring to a LIRA much less attractive.
2. INDEXED BENEFITS
Indexed benefits can substantially add to the amount of money needed at retirement to fund the same pension – and this is especially true if benefits are indexed prior to retirement as well as after retirement. In Brad’s case, the two per cent indexing starts at retirement. If his pension plan also indexed income at 1.5 per cent during the 15 years before retirement, he would need to accumulate about $562,500 to fund an annual pension of $33,750. The required rate of return to build that nest egg would be 4.2 per cent if Brad invests all available dollars, and 5.5 per cent if he only invests the locked-in portion.
3. HEALTH AND DENTAL BENEFITS
While reviewing Brad’s options statement, Chris notices that Brad’s company offers health and dental benefits to employees who are considered to be retired. If Brad transfers to a personal LIRA, he will be considered a terminated employee rather than a retired employee. He will have to calculate the additional cost of private coverage – and consider the benefits his new employer offers – before making a final decision about whether to take the commuted value or not.
4. FORMER EMPLOYER’S FINANCIAL STABILITY
Brad works for an established company and is confident in its future prospects. He also has a good working relationship with his former employer and is leaving on positive terms. He has no personal issues and is not concerned about dealing with them in the future. However, if he were not sure that his employer would still exist or be financially able to meet its pension promises over the long term, or if he would prefer to cut all ties, this could be another reason to take a lump sum today to avoid any uncertainty with respect to his retirement income in the future.
5. PENSION ADJUSTMENT REVERSAL
If Brad decides to transfer the commuted value of his pension to a LIRA, Chris advises him that a pension adjustment reversal (PAR) will be calculated. A PAR will not be calculated if Brad leaves the benefits with his former employer.
A PAR results when the pension adjustments reported while earning benefits after 1989 are greater than the commuted value actually paid out for those benefits. It restores RRSP room equal to that difference and may allow Brad to avoid taxes on some or all of the lump-sum amount not normally transferable under the maximum transfer value rules. If Brad is eligible to receive a PAR, his former employer will advise him of the amount. Julie and Brad leave their meeting with Chris feeling much better informed about their pension options. They understand the factors they need to consider as they come to a decision about whether to take a commuted value or leave Brad’s pension on a paid-up basis with his former employer. In the end, Julie and Brad choose to transfer both pensions to LIRAs so they can control the assets and take advantage of the broadest possible range of investment choices.
1 The commuted value of a pension benefit refers to the amount of money that needs to be set aside today, at current market interest rates, to provide sufficient funds to pay for a pension when a plan member retires. The rates of return used are for illustration purposes only.
Content provided courtesy of Manulife Investments
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