Commuting a registered pension plan

The why, when and how to your decision

Whether you are headed into retirement or changing jobs at an earlier stage of your life, one of the largest financial decisions you face when you leave an employer is what to do with your retirement savings.

If you have been saving in your own registered retirement savings plan (RRSP), there’s not much more to say as it already belongs to you. Even when it is a group RRSP arranged through your workplace, generally the accumulated amount is yours to keep, though you’ll likely have to transfer to other investment choices.

If instead your work has a registered pension plan (RPP), there’s more involved.

Distinguishing registered pension plan types

You may be allowed to stay in your employer’s RPP, move to a new employer’s plan, or transfer into a locked-in retirement account. Depending on the type of RPP, that last option can be relatively straightforward, or it can be a multi-part process to arrive at the pension value, including potential immediate tax fallout.

Pensions come in two main varieties: defined contribution (DC) plans and defined benefit (DB) plans. Some plans are hybrid arrangements that have elements of both.

Defined contribution plans

Under a DC plan (also called a ‘money purchase plan’), the employer’s obligation is the amount to be contributed.

The employer as the pension sponsor must contribute a certain amount to the plan each year. Sometimes there may also be employee contributions. You will be able to choose among the investment options within the plan, with all income and growth tax-sheltered. The accumulated value is what is available to provide your retirement pension, which by default is paid as an annual annuity.

If you leave prior to retirement, the plan may be transferred dollar-for-dollar into a locked-in retirement account, where your investments may continue to grow tax-sheltered. The main feature of being ‘locked-in’ is that there is a maximum amount you can draw from it each year, which is intended to limit depletion so that it is sustainable through your retirement years.

Defined benefit plans

By contrast, under a DB plan the employer’s obligation is the pension benefit to be paid in future.

The employer must provide a retirement pension as determined by a formula. An actuary calculates the employer’s required contributions, based on the number of plan members and their respective rights. Those contribution amounts are adjusted from time to time according to past investment experience and future economic expectations.

You will be entitled to a retirement pension according to a formula in the plan (more on that below). If you leave before retirement and want to take your funds with you, once again an actuary is needed to determine the value. That’s where the complications really set in.

The remainder of this article focuses on commutation of a DB plan, first in terms of valuation and tax effects, and then on to how to approach this decision based on your particular needs.

Between you & your employer: Gross commuted value

A DB plan annual retirement pension is determined by multiplying a base income times a credit rate times years of employment. The base income and credit rate are negotiated between employer and employees. The base could be (for example) the average of your last five years of employment income, or better yet your best three years’ income. The credit rate generally ranges from 1% to 2% per year of employment.

If you leave prior to retirement, an actuary has to determine the value of your entitlement in the accumulating pension fund. On the face of it, it’s that annual pension discussed above multiplied by a present value (PV) factor. The PV factor is essentially an interest rate, but one requiring numerous inputs to derive, the main ones being current age, assumed commencement date (less any reduction for starting early), continuation provisions (e.g., to spouse), any guarantee period and any annual indexation.

The result is the lump sum current amount that would be required to pay the projected annual pension to you over your expected lifetime. For the sake of the calculation, it is assumed that the lump sum will be invested at long-term interest rates. Accordingly, commuted values tend to be higher when prevailing interest rates are low, and lower when interest rates are high.

Between you & the CRA: Maximum tax-free transfer to a locked-in plan

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.

In structure, the tax rule is similar to the commuted value calculation above. In tax terms, it multiplies your “lifetime retirement benefits” by a PV factor. In this case though, the PV factor is less generous 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. In a sense (though not literally), you might think of the tax calculation as what you would have accumulated under the RRSP rules, and therefore that’s the amount that you are allowed to transfer into a locked-in retirement account.

The excess amount will be taxable in the current year. While this is obviously not a pleasant prospect, it is applying tax to the more generous terms of the DB RPP, but you still get to keep the after-tax amount. The impact of this may be deferred if you have unused RRSP contribution room and choose to make a corresponding contribution.

Considerations before deciding to commute

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:

1. Investment of the commuted value may ultimately deliver a larger retirement income, but this should be balanced against downside investment risk. Some people like to make investment decisions, while others shy away. A conversation with your financial advisor can help you decide.
2. Are you comfortable leaving behind indexing and guarantees that may have been part of the original pension?
3. Do you want to be able to adjust income from year to year, or ever make a lump-sum withdrawal? As locked-in plans put a cap on annual withdrawals, a commuted pension may be needed for this kind of flexibility.
4. Some pension plans allow continued health and dental coverage (at least for some period of time), which can relieve your budgetary costs in retirement.
5. On the other hand, if you have health concerns that may affect your life expectancy, you may prefer to take the commuted pension as a sure thing to be able to pass on the remaining value to your beneficiaries, especially if you have no spouse.
6. Spousal pension income splitting is available under age 65 from a registered pension plan, but generally only from age 65 for an individual life income fund. Does this affect your income plans?
7. Beyond a spouse, you may wish to leave a legacy to family or charity. Managing a commuted pension amount may provide an avenue for that kind of planning.

Spousal rollover … or not?

To defer, or prefer to incur

After a good long run, dad died midway through his 99^th year. Mom and we kids will miss him dearly – they actually called each other “dear” – but it was his time.

Mom is nearing the mid-90s herself. Customarily, everything would roll to her to get around the tax on deemed dispositions at death that would otherwise erode dad’s estate, of which mom is the sole beneficiary – But could we do better for her?

It’s one of those mantras of financial planning to arrange beneficiary designations and joint accounts to allow streamlined continuity to a spouse. Even so, it’s equally important to pause and consider whether to opt out, particularly for deaths early in the year. Dad died in January, so with only a couple weeks of income, there remains plenty of room to make use of his basic personal credit and low bracket tax rates.

Following are some steps we undertook, along with the odd snag along the way.

Pension rollover

To begin, notice was given to the administrator of the defined benefit pension that was their primary income source. As surviving spouse, mom will continue with a reduced pension, emphasizing the need to be tax-conscious with her other income sources. There won’t be any residual value when she dies, but with the two of them living well into their nineties, they got their fair actuarial share out of the deal.

RRIF on death

Mom handled the house when we were youngsters, followed by a lengthy run as a school trustee. Dad took early retirement at 60, then kept busy with teaching and consulting gigs into his 70s. Thus, despite having a dependable pension, both had moderate accumulation in registered retirement income funds (RRIFs), each naming the other as beneficiary. Their financial advisor (a friend to us all) readied the paperwork to roll dad’s RRIF to mom.

Acting under power of attorney (POA), we instead declined the receipt of the RRIF on mom’s behalf. Accordingly, the amount will be included in dad’s final year income, soaking up the remainder of his basic personal credit (i.e., at zero tax), with the rest tagged with the lowest bracket rate.

RRIF minimums

In their later years, we have been managing their finances under POA. This included instructing on taking the minimum RRIF withdrawal early in the year. That meeting was still in the upcoming calendar when dad died.

The RRIF minimum, based on the preceding year-end value, is required to be paid in the following calendar year. Per CRA and the administrator’s practice, as it had not been paid before dad’s death, that portion had to be paid and taxed to mom as the named beneficiary (though again as noted above, the bulk had been declined, to be taxed in dad’s final year).

TFSA rollover

One great thing about a TFSA rolling to a spouse is that it continues to be a TFSA, without requiring or using up the receiving spouse’s TFSA room. Notably, unused TFSA room does not roll to a spouse, nor to anyone else for that matter. Fortunately, mom and dad were consistent TFSA contributors, with the combined amounts now being with mom, except for the lost room for dad’s final year due to the contributions not having yet been made.

(Not) naming beneficiaries under POA

For registered accounts in Ontario (and most common law provinces), attorneys under POA cannot initiate or change beneficiary designations. However, many financial institutions will carry over an existing designation on an incoming registered plan, which was helpful as we were consolidating their financial holdings when their faculties had significantly declined.

Unfortunately, dad had one small TFSA without a designation. As we could do nothing about it, probate was inevitable for dad’s estate. On the bright side, it bolstered our decision to allow the RRIF to fall into the estate, with the projected income tax savings well exceeding the nominal bump in probate tax.

Joint non-registered account

The proceeds from their home sale years ago went into mom and dad’s joint non-registered investment account. That’s helped service their later accommodations, while also appreciating nicely. Probate was bypassed at dad’s death, with mom continuing as sole legal and beneficial owner by right of survivorship.

By default, capital property rolls at adjusted cost base (ACB) to a spouse on death. This applies when held through a joint account as in this case, or if dad had an account under his name alone that was then migrated to mom as estate beneficiary (as long as the individual securities in the account were not sold in the process).

Alternatively, dad’s estate can elect out of the automatic rollover, on a per-property basis. This will allow us to optimize for mom’s future needs by choosing which securities to rollover, and which to have taxed on dad’s final return. As mom could conceivably blow right past dad, the century mark and beyond … that extra financial flexibility will be welcome comfort for her as she moves into this next chapter.

Bringing a foreign pension to Canada – A two-step technique

Our nation was born through immigration, and it continues to welcome new arrivals in a steady stream. While some newcomers will be at the start of their careers, many will be arriving in the midst of their working lives.

Frequently, immigrants have significant tax-sheltered savings in foreign pension plans, and may wish to bring those funds over to their new home in Canada. They may be shocked, however, to learn that our system does not allow tax-free transfer of foreign pensions to Canadian registered retirement or pension plans. However, all is not lost.

If appropriate steps are taken – on a timely basis – the net result can be continued tax-sheltering of their retirement savings.

No direct transfers

While it may seem harsh to not allow direct tax-free transfers, it’s simply not practical for our tax system to be so intimately intertwined with foreign tax systems.

Instead, our system makes allowance within the domestic tax rules once the person has collapsed the foreign pension. As this “deregistration” of the foreign pension is likely irreversible, at minimum the person will want to be certain:

what gross and net-of-tax amounts are involved,
that the particular plan and transactions qualify, and
whether the actions can be completed in the required time frame.

Step 1 – Foreign tax procedure

Generally, the pension administrator will be required to withhold taxes according to the foreign jurisdiction’s laws. This may include the administrator evaluating the nature of the transaction to determine whether it has a withholding obligation at all and, if so, for what amount. The amount of withholding tax may in turn be reduced if there is an applicable provision in the tax treaty Canada has entered into with the foreign state.

Some jurisdictions also impose penalties on some withdrawals, for example when taken below a specified age. It is highly unlikely that treaty relief will apply to these additional penalties.

The Canadian resident will receive a payment denominated in the foreign jurisdiction’s currency, net of all withheld amounts. Unless there is a continuing connection, this withholding will usually satisfy the person’s final tax obligation on the pension to the foreign jurisdiction.

Step 2 – Canadian tax calculation

Income inclusion

Canadian residents are taxable on worldwide income. Accordingly, the gross amount received from the foreign pension, converted to Canadian dollars, must initially be included in calculating Canadian tax liability.

The withheld foreign taxes entitle the person to claim a foreign tax credit when calculating this initial Canadian tax due. Depending on the circumstances, however, the credit may be less than the withheld amounts (see provisos below).

Special RRSP/RPP deduction

A special deduction will be allowed if the pension satisfies the Canadian definition of superannuation, pension benefit or foreign retirement arrangement. Additionally, the payment must be a lump sum and specifically not be part of a series of periodic payments.

The deduction is in the form of an allocation of contribution room toward either a registered pension plan (RPP) or registered retirement savings plan (RRSP). Though not obligated, the person may make an RPP or RRSP contribution up to the amount taken as income as a result of collapsing the foreign pension. This does not require or affect existing contribution room.

The special deduction must be used in the same taxation year as the income inclusion or within the first 60 days of the following year. To be clear, any unused room from this allocation cannot be carried forward.

Some practical provisos

Bear in mind that the actual payment received from the foreign plan will be net of withheld amounts. If the person wishes to take advantage of the full contribution/deduction, other cash will be required for that top-up. On the other hand, if the amount is not topped up, then Canadian tax will still be due on the difference between the gross income amount and the chosen contribution.

The foreign tax credit is limited to the lesser of the actual foreign tax paid/withheld (up to a maximum of 15%) and the Canadian tax due on the foreign-sourced income. The credit may thus be less than the withheld amount. Furthermore, this type of credit cannot be carried forward for use in future years.

As you’ve likely come to realize, determining how to deal with a foreign pension can be a complicated matter. As a starting point, the person should obtain a clear statement from the pension administrator as to the procedure and amounts from that end. The statement can then be analyzed with the person’s tax advisor to determine how best to proceed.