This article originally appeared in our sister publication, Conseiller. Read the original version in French here.
Do you have a client who has changed employers or been laid off? If they were a member of a defined benefit pension plan, they may have to choose between keeping a pension or opting for the commuted value. As an advisor, you can help them make an informed decision.
Usually the commuted value is mathematically equivalent to the value of the pension offered by the plan. This is based on a principle of neutrality. With this principle in mind, you can use the following two steps to properly assist your client.
The first step should be quantitative. It involves completing a retirement projection for the client (and spouse, if they share their finances).
The second step should be qualitative. It allows clients to consider their personal preferences as part of the criteria for making the decision, notwithstanding mathematical calculations. This step allows you to explain both sides of the coin to clients.
The criteria are:
- Total income and assets
If the client needs all their income to pay for the cost of living in retirement, a pension is a better choice. Conversely, if the pension only represents a small percentage of income at retirement, the commuted value could be a better option. If the client’s expenses are modest given their assets, the commuted value would be less of a concern, since a buffer is available to mitigate disappointing returns.
- Investor profile
Pensions offer peace of mind. They are best suited to clients with conservative investor profiles and little investment knowledge, and who are concerned about stock market volatility.
The commuted value option may be attractive to clients who have achieved financial independence and have a higher risk tolerance. They could potentially obtain better returns by investing the funds in an investment portfolio.
Life expectancy is also an important consideration. For clients in good health or looking to protect a spouse, the pension is a better choice.
Clients with a reduced life expectancy or in poor health may favour the transfer value. This is especially true in cases where the client does not have a spouse or wants to protect adult children in case of premature death. Although certain pension benefits can sometimes be recovered, it is possible that heirs other than a spouse would not receive benefits when the beneficiary dies.
For clients who tend to spend every last dollar without budgeting, a pension will protect them from themselves. However, this choice eliminates all flexibility.
If they need flexibility in their income to address irregular expenses, the commuted value can be an attractive option. The pension will have to be transferred into a locked-in retirement account (LIRA). If the client needs to withdraw funds, the LIRA will be converted into a life income fund with minimum and maximum withdrawal thresholds. You will have to make sure this constraint is not a problem before making the transfer.
- Tax repercussions
If opting for the commuted value could result in a major tax bill, a pension is a better option. With pensions, clients can split up to 50% of income.
Meanwhile, the commuted value can be used to optimize withdrawals based on the tax rate and the impact on Old Age Security benefits, as well as postponing when the client withdraws funds in order to reduce the income taxes to be paid.
- Benefits and specific points related to pensions
If selecting a pension allows the client to keep certain benefits or simply enjoy enhanced benefits under a plan on an ad hoc basis, it is a better choice.
- Plan’s financial situation
If the plan is solvent and the pension is enhanced, plan members will benefit from it while those who opted for a transfer will receive nothing.
If the plan has a deficit, the commuted value will only be paid as a function of the solvency ratio, unless otherwise stipulated in the plan.
After completing a quality retirement projection and discussing these seven elements with your clients, they will be able to make an informed decision.
Charles-Antoine Gohier, Financial Planner, MBA, is the Practice Lead, Financial Planning, Wealth Management Solutions Group at National Bank Financial