Leaving employment can be an emotional event, whether initiated by the employee, forced by the employer or undertaken in concert; for example, under an early retirement program. Obviously, it is also a significant financial event, with both current effects and life-long implications.
Where a defined contribution (DC) or defined benefit (DB) registered pension plan is in place, the departing employee will commonly have the option to continue in the plan, or to transfer to a new employer’s plan or a locked-in retirement account.
In the case of a DC plan, this is fairly straightforward. On the other hand, the commuted value of a DB plan has to be determined by calculation, and can be particularly high in a low-interest-rate environment. While this clearly has its appeal, the procedure and tax implications are more complex. Ultimately, an informed decision should be tailored to fit the individual’s current needs and future expectations.
Commuted value of the pension
Under a DC plan (also known as a money purchase plan), the known element is the amount of the employer’s contribution obligation. These contributions grow tax-sheltered, with the amount of the pension based on accumulated value at the retirement date. If an employee departs prior to retirement, the plan may be transferred dollar-for-dollar into a locked-in retirement account.
By contrast, the employer’s obligation under a DB plan is to provide a calculated pension amount, irrespective of the contributions required to get there. An actuary is involved at the outset and on an ongoing basis in calculating the employer’s funding obligation, which will be adjusted from time to time according to past investment performance, future economic expectations, and the number and characteristics of plan members.
If an employee departs a DB plan prior to retirement, it will be necessary to obtain an actuarial report to determine the value of that person’s entitlement in the accumulating pension fund. The formula is deceptively simple:
[annual pension] x [present value (PV) factor]
The annual pension is the expected amount that would be due at the normal retirement date. That’s the easy part. On the other hand, the PV factor depends on a myriad of inputs, including:
- Age at calculation date
- Gender
- Assumed commencement date
- Any applicable reduction factor for early commencement
- Continuation provisions (e.g., to spouse) and any guarantee periods
- Indexation, if any
- Adjustments that may be required by the jurisdiction’s pension legislation
The ‘how’ of combining these inputs is governed by the Actuarial Standards Board in section 3500 of its Standards of Practice for Pension Plans. Be forewarned if you plan to look this up; it is not for those who are faint of heart when it comes to arithmetic.
Maximum tax-free transfer
The commuted value from the actuary’s report should not be confused with the amount that can be transferred into a locked-in retirement account. The commuted value is essentially a property right between an employer and an employee, whereas the transfer amount is a fiscal issue between Canada Revenue Agency and a taxpayer.
The relevant rules are in Income Tax Act (Canada) section 147.3(4) and Income Tax Regulation 8517. In a similar manner to how the commuted pension value is derived above, the maximum amount that is transferable to a locked-in registered account is prescribed under the regulation as:
[lifetime retirement benefits] x [PV factor]
There are a number of factors affecting the lifetime retirement benefits figure, but at the core it is the annual pension the retiree would otherwise have been entitled to eventually receive.
The present value factor is laid out in a table in the regulation according to the person’s calendar-year age. It is 9.0 below age 50, rises to a peak of 12.4 at age 65, then declines to 3.0 for age 96 and over.
This PV factor is narrower than the commuted-value PV factor outlined above. For example, it doesn’t account for any indexing or early retirement benefits. As a result, the tax transfer value is often less than the commuted pension value. The difference or excess amount will be taxable in the current year, though the impact of this may be reduced if the person has RRSP contribution room and chooses to make a corresponding contribution.
Decision considerations
Apart from the value of the commuted plan and tax transfer, here are some surrounding issues to review before committing to a course of action:
- Investment of the commuted value may ultimately deliver a larger retirement income, but this should be balanced against downside investment risk
- Is the person comfortable leaving behind indexing and guarantees that may have been part of the original pension?
- Does the person wish to adjust income from year to year or ever make a lump-sum withdrawal? Subject to provincial limits, this will generally be possible only if the pension is commuted
- Some pension plans allow continued health and dental coverage. In contrast, a person in poor health may prefer to take the commuted pension due to a shorter life expectancy
- Spousal pension income splitting is available under age 65 from of a registered pension plan, but generally only on or after age 65 for an individual life income fund
- Beyond a spouse, a person may wish to leave a legacy to family or charity. Managing a commuted pension amount may be the easiest way to facilitate such a plan