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“OMG, You have no idea what just happened!” a friend recently texted us.
“What? What?” I texted back.
“I did what you suggested, and I just heard back from my HR department. All I can say is: WOW!”
Let me back up a bit.
Defined Benefit vs. Defined Contribution Pension
Over the years pensions in the private sector have largely gone the way of the dodo. Most companies these days, when they offer retirement benefits at all to their full-time employees, do it in the form of a defined contribution, or DC pension. How these work is that basically they top up, usually expressed as a percentage, your own contributions to your retirement accounts. So for example, if you put in a $1000 contribution into your RRSP or 401(k) plan from your paycheck, the company might chip in, say 50% or $500 extra up to a yearly cap. These are called defined contribution because how much the company contributes is explicitly defined. What you do with that money is up to you.
A traditional pension, on the other hand, is a defined benefit, or DB pension. With a defined benefit pension, the company (or more accurately, the company’s pension administrator) takes money out of each paycheck and invests it on your behalf inside a collective pension fund. Then when you retire at 65, the pension adminstrator pays out an amount to you each month for the rest of your life. These are called defined benefit because how much you receive each month in retirement, or your benefit, is explicitly defined. You don’t have to manage any investments yourself.
Defined benefit pensions are way, way, way more complicated (and more importantly, costly) to run. And as a result, most private companies no longer offer them.
However, some people still have them. We shall refer to these individuals as “Lucky Bastards.”
Maybe these Lucky Bastards work for a government agency, or at an employer with a long history that has pensions grandfathered into their benefits packages. Whatever the reason, these people still have access to these gold-plated dinosaurs that the rest of us peons can only dream of.
What Happens To A DB Pension When You Quit
Pensions are built assuming you work at the same company until you retire at 65, but as we all know this assumption is just a fantasy these days. People change jobs, get laid off, or quit with far more regularity than our Boomer parents. So nowadays, when employees either voluntarily or involuntarily say sayonara to their company, they get presented with a choice about what to do with the pension credits they’ve earned.
Option #1: Leave it With the Company
In this scenario, whatever you’ve earned in the pension you get to keep, but you obviously stop accruing more because you no longer work for that company anymore. Then, when you reach your normal retirement age of 65, you’re supposed to go back to the company and claim your benefit, at which point they start paying you your monthly payment. Obviously it won’t be as much money as if you worked there your entire career, but it’ll be something.
Option #1 is almost always the default option. The company really wants you to pick this option because a) they don’t have to do anything, and laziness always wins, and b) if you die before 65 or you forget to claim your pension when you turn 65, they get to keep your money.
Option #2: Transfer it To Another Company.
In this scenario, you leave your old company and go to a new company. If this new company also offers a DB pension, rather than start acruing from scratch all over again, you can apply to transfer the amount that you’ve accrued from your old pension into your new pension. So for example, if you worked for company A for 10 years, and then you switch jobs, you can take the 10 years of pension you’ve earned with company A and transfer it into company B. That way, your first year working in company B will accrue as if you’ve been working with company B for 10 years already.
This option is pretty rare in my old field (tech) because it requires that your old job has a DB pension, your new job has a DB pension, and that the two pensions are compatible enough to accept transfers from each other. Literally none of those assumptions apply in tech, and they don’t even apply that often in finance either, but in some fields this is a useful tool.
Teachers, for example, who transfer school boards can take advantage of this.
That’s literally the only example I can think of, though. That’s how rare pensions are these days.
Option #3: Take the Commuted Value
The third option is the interesting one. If your pension plan allows it, you can ask your pension administrator to calculate the pension’s commuted value, and then you can ask them to pay that amount to you personally.
Note that “commuted value” is not a universally used term. Some plans refer to it as “present value.” Other plans refer to it as “lump sum.” But the concept is the same. It refers to how much the pension would be worth right NOW as a sack of cash rather than the future promise of monthly payments.
Not every plan even offers this option. Every pension is different, so you have to ask. Generally in Canada, federally regulated pensions are required to offer this option, but in the US the pension has to be set up as a “cash-balance plan.” You have no control over what type of pension you have. Your employer chooses for you. So the first step if you’re reading this is to shoot your HR department a quick email and ask whether your pension (if you have one) can be cashed out in this way.
And finally, if you are eligible to receive the commuted value of your pension, there may be restrictions on when you can access it. In Canada, the money will go into a Locked-in Retirement Account (or LIRA) that places age-based restrictions on when you can withdraw the money. And in the US, the amount gets rolled into your IRA.
That being said, it’s still possible to access these locked-in amounts to fund your early retirement. If you’ve read our book, you’ll know that we came up with a technique to access the dividends earned in our LIRA called the Cash-Asset Swap. And for Americans, we also described a way to access your IRA using a technique called a 5-year Roth IRA Conversion Ladder. So restrictions be damned, gimme my money!
How much is the Commuted Value?
OK so now that we’ve explained Commuted Values and why it’s important, let’s get to the really important question: How big is my sack of cash?!?
And annoyingly, the answer is: it depends.
How your commuted value is determined is not a simple formula. Actuarial software needs to get involved, and a good general rule is that once actuarial anything needs to get invovled, things get confusing super-fast.
Don’t worry, I won’t make you read MATLAB code. I did it for you. Here’s what I learned are the major factors that determine your pension’s commuted value.
Your Salary
The more you earn, the more your pension will be worth. Pretty intuitive, because your pension contributions are a percentage of your earnings, so the more you contribute each paycheck, the more your pension payouts will be. Again, pretty intuitive, so lets move on.
Years of Service
Again, pretty intuitive. The more time you worked at a company, the bigger your pension will be, and the more your commuted value will be worth.
Your Life Expentency
This is the part where the actuaries get all turned on. This is the part where the actuarial software takes in your age, race, how much you smoke, etc. and figures out how long you’re likely to live. The longer you’re expected to live, the more your pension will be.
Interest Rates
And finally, interest rates. Pensions are madated to provide steady, guaranteed income to their clients for as long as they live, and the only way to get guaranteed income is for the pension funds to invest part of their money in bonds.
That’s why interest rates matter. If safe, secure government bonds are paying a ridiculously high interest rate, like 10% in the 80’s, then your pension doesn’t need to be worth that much money. But if interest rates are low, then the regulations that govern pensions would cause the commuted value of that pension to be much, much higher.
Email Your HR Department!
The first 3 factors in that calculation aren’t that interesting. Having a higher salary and working longer are obvious ways of increasing your net worth, but both of those factors are out of your control right now during this shitty, shitty year. Your life expentency is also largely out of your control.
But you know what’s in a ditch right now? Interest rates.
In every major economy in the world, central banks have dropped their interest rates down to damned-near zero. As a result, savings accounts have been massacred. Mortgage rates have also crashed causing a strange, unintuitive jump in housing prices, and it’s also caused people’s commuted value of their DB pensions to skyrocket.
In other words, when interest rates are unbelievably low (like right now), your lump sum could be insanely high.
“Holy shit!” our friend giggled as she sent us a screenshot of our pension statement.
It was multiple times her annual salary.
“I think…” I scratched my head, staring at the number of zeros on my phone. “I think you just became FI…”
So if your workplace has a pension, ask them for you commuted value right now. You might be a lot closer to FIRE than you think.
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I’ve wondered how these work, with only the foggiest idea. I’ve never been with a company with a pension or have any close relationships with people who do so it’s not really been top of mind. Thanks for explaining.
I’d think, more often than not, the math would favor taking the pension payout assuming you can easily reinvest the money yourself in something like an index fund/bond mix that’s pretty safe.
I work in health care and have paid into defined benefit pension just under 20 years. The commuted value today would be $750 000 CAD. That is a shockinly high amount! After initial tax hit, I wonder how much would be left. Still, lucky me and anyone with DB-pension. I have entertained with the idea of taking the commuted value in my early 50’s which is still a few years away… but will see. I like my job.
Wowee, that is amazing! Congrats! You can’t afford NOT to quit 🙂
Thanks for the article – timely as I am just trying to understand how my DB pension will play into my FI plan. I work for the BC government and, unfortunately, the BC pension plan will not calculate my commuted value until I give notice to my employer. Short of hiring an actuary, does anyone have any wisdom? I’m thinking I’m 8-10 away from being in a position to retire. Thanks!
Yeah, every pension has its own set of rules. Guess they don’t want you to take your money and run if what they owe you turns out to be too high…
I checked and the value didn’t change much from a year ago.
It’s a tiny pension so it won’t make any difference anyway. A lump sum would pay out just $30,000 or so.
Maybe it works differently in the US. I’m not sure if there is a mandate to provide a steady income. Here it might be – you get what you get and it’s your responsibility to make it work.
haha, way off on the life expectancy section. Pension actuaries don’t consider individual mortality and life style factors. All of the pension mortality tables are based on studies of large groups. These studies are then legislatively required to be used on commuted value calculations. So, a 56 year-old smoker with the same salary/service history as a 56 year-old non-smoker, would get the exact same pension.
Oh, interesting. The open source actuarial software I found seemed to take into account individual factors, but hey if you’re in the field then you’ll know better.
It was probably software for an annuity provider, not a pension plan. To elaborate on my example, the two 56 year olds would get the same lump sum from the pension plan, but would likely receive different amounts if they took that lump sum and purchased an individual annuity from the private market.
Depending on how much the commuted value is, it may exceed the amount that can be contributed to the LIRA.
Which would mean the remainder is a cash pay out… if you have room in your RRSP, you can put it there. If not then there would be taxes owing on the remainder as it is considered income for that year.
I just quit my nursing job after being dicked around during covid, and I took the commuted value of my DB pension (which was just under 1 million!) I maxed out my TFSA, RRSPs and $360,000 was put into a LIRA of which 50% I was able to unlock. Approximately $250,000 in taxes paid, I was left with a good chunk leftover! Taking the commuted value was the best decision I ever made. I can still work if I want to… Not!
Holy moley that is an amazing result !!!
Very nice! Congratulations! 🙂
How were you able to do the 50% unlock? Are you over 55 and converted to a LIF?
I was 54 in May, when I decided to take the commuted value of my pension but I turned 55 a few weeks after receiving it in July. So yes, I was 55 and it was converted to a lif. Hope that makes sense!
Yikes that is amazing! So in a way, you’re retired all thanks to COVID?
Tigermom is most worried about the upfront tax bite…..let’s hope our friend Doug offers some good packages in the November budget 😊
Yeah, it can be a lot of tax, especially if you are paid out in a year with full time income and/or a severance package.
Ways to reduce this include:
– make an RRSP contribution if you have room (as per LeoK’s comment);
– defer your election of receiving your commuted value until a new tax year in which you don’t have other employment income;
– make a Spousal RRSP contribution if you have a spouse with contribution room.
In Canada, if you have a “federally” regulated LIRA or LRSP (after taking a pension payout/commuted value/transfer value from a Federally regulated employer), then you can start making withdrawals at any age. Provincial plans may vary….some only allow this after age 55.
You can convert your LIRA/LRSP to a Life Income Fund (LIF) – usually at no cost, and without having to sell any assets or triggering any gains. Once it is a LIF, there are minimum and maximum withdrawal amounts. The minimum and maximum amounts are dependent on the account holder’s age, and prevailing bond interest rates.
For example, if you are 40 years old and have $400,000 locked in to a LIRA (from leaving a federal job like the military, RCMP, public service etc), then you can convert it to a LIF and withdraw up to 3.8836% of your account balance on January 1st (2020 rate), which would be $15,534/year in our example. Not too shabby. This could bring someones “Retire Early” date quite a bit earlier, with an extra $1000/month or so in after-tax income (due to some withholding taxes).
This is a strategy you may consider if you are retiring/retired early, expect to be in a lower tax bracket from now until your 60s, and want to preserve your ability to qualify for certain benefits like OAS (after age 65).
The alternative would be to keep investing it while having it locked up in the LIRA/LRSP, but then decades down the road this account will likely be much bigger, resulting in withdrawals placing you in higher tax brackets (you get less after tax money for each dollar withdrawn), and also more likely to keep you from qualifying for some government benefits. This would be an unfortunate sort of double taxation. If you can start drawing it down efficiently, it makes sense to do so when you can.
I have converted my LIRA to a LIF and will start drawing income in January (age 38) as I will no longer be in receipt of full time income and will be in a lower tax bracket.
Here is a link to the current rates allowed for withdrawals. Expand FAQ #2 to see the table:
https://www.osfi-bsif.gc.ca/Eng/pp-rr/faq/Pages/lif-frv.aspx
Hi Sandra,
Just curious, how the fiscality applied on your commute?
I always assume that the commute pension goes wolly into a LIRA. Having to pay 1/4 of that in taxes before putting the capital on the financial market change a lot of my personnal plan.
So I am very curious about how your LIRA space is calculate when you receive your pension!
I may be able to help with this one. Once the actuarial present value is determined (again a very complicated process….so best just get the commuted value amount from your HR department), you will be presented with the total commuted value.
Some of it, up to what’s called the “inside limit”, must be transferred to a locked in account. This inside limit is also known as the amount within tax limits. This limit is something else that should be provided by your HR department. If not, then perhaps this article may help: https://www.advisor.ca/columnists_/lea-koiv/understanding-maximum-transfer-value-rules/
Basically any amount between your inside limit and the total commuted value, is subject to taxation, unless you have room in your RRSP (or spousal RRSP). Typically there will be 30% witholding tax for the “outside limit” amount….and depending on your marginal rate, at tax time you may end up paying more.
So let’s say you have a total $150K commuted value (total benefit), and your inside limit is $60K, then our outside limit would be $150K-60K = $90K. Your $60K would go in to a locked in RRSP or a LIRA, and you would receive a cheque for $63,000 ($90K minus 30% tax withheld).
Thank you alot Kevin!
I have read your article, and yet doesn’t understand the legislator/rule maker intent with the maximum transfer value and how to calculate the Lifetime retirement benefit which is use to calculate the maximum transfer value…
Isn’t that wonderful how everything become complex when there are present value calculation needed!
I’ll have to call my pension administrator to get them to calculate those number I figure…
For the moment my counterintuitive conclusion is that I need to stop maxing my RRSP!
Wanderer, your option 2 is applicable when you are a career public servant and change the government that employ you. (Canada/Province/Municipalities)
Would you keep a Defined Benefit plan with a 4% state-legislature-set interest growth each year as part of your bond allocation? (Given our anti-labor history I have feared that at any moment our state legislature will pull the rug out from employees and lower this rate or just change the rules altogether.)
Market interest rates apparently *do not* factor in for the payout/transfer for my DB plan. (I wish!) When I talked with a Fidelity representative in the early stages of my FIRE education & journey – he encouraged me to hold onto it.
If you were me, would you hold onto a DB plan with 4% interest as part of your bond allocation? It’s currently about 15% of my ~22% overall bond allocation. Though I had* been nudging myself in the impatient direction of even more stocks. (Thank you, Wanderer, for the “20% bond minimum, less isn’t worth the risk” reminder in your recent video with Unconventional Asians!)
Looking at other bond options and what they have yielded over 10+ years, this sounds like a sweet, rare, thing to hold onto until a few years before traditional age-based retirement. I have done some calculations, and don’t plan to wait until I’m eligible for to the actual Defined Benefit payment of a few hundred dollars a month.
Are there other considerations I’m leaving out?
4% guaranteed growth ain’t bad at all. I’d hang on that and treat it as a high-yield bond.
Defined contribution pensions are a different thing entirely than what you’ve described. You’re right that company RRSP contributions are a ‘defined contribution’ *plan*, but ‘defined contribution pensions’ are pensions where what employees pay in is defined, and the pensions that they are paid out depend on market outcomes. This allows pension funds managers (with board approval) to adjust payments to ensure the sustainability and continuity of the pension fund in the event of a 2008-style shock. UBC, for one, moved to this structure, I think in the aftermath of the great recession, and I know other large institutions are moving towards it.
I’m not usually a fan of the term “gold plated” when it is applied to DB pensions. Do I consider myself lucky to be with an employer that offers one? Yes. Everyone should have one. But the average annual pension payout is around $18K, so hardly gold plated. Such terms are sometimes unjustly thrown around by ne’er do wells to support initiatives for removal of said benefits. That being said, good writeup.
Great article Wanderer. Everyone should know the commuted value number but even more importantly exactly how their pension works. What is the unfunded liability? Are there ways to increase your pension? When can you start – age 55, 60,65? How is the pension affected if one/both partner(s) pass? Is there a “bridging” with CPP? How much potential government or employer interference could there be? Is the pension fully/partially indexed to inflation? Do you get to commute both employer and employee contributions?
I considered commuting my teachers pension but realized I would pay a $100K+ in taxes, that I would need a minimum of 6.3% annualized return to match what I would receive without accounting for inflation. Not impossible but also not guaranteed.
Left teaching at 56 and two years later I don’t regret leaving it with pension manager.
I treat my pension like the bond portion of my income so technically I am 77% fixed income and 23% equity. Managed to replace 85% of net salary without working.
If I had married a teacher I would look at commuting one pension and leaving the other.
My annual pension is equivalent to having over a million. I could never save that much in a 30 year teaching career. Don’t let that large dollar amount make you star struck. Commuting is irreversible. There are good reasons to commute and good reasons to leave it alone.
Another consideration is the tax owing while collecting pension. Pension income splitting in Canada allows me to split my pension income with my spouse at any age. That makes us both eligible for pension tax credit. Splitting also dropped our effective tax rate to under 8% for 2019. You cannot do that with RRSP/RRIF until age 65.
DB pensions are still out there. I did #2. Transferred my partial military pension to my emergency services pension. I have lots of army buddies that either took a lump sum or transferred it to fire, police, ambulance or nursing. I’m sure it could be done with teachers, correctional officers or CBSA.
Do you know any company that have been well for your entire lifetime? What happen when a company go bankrupt?? You lose A LOT. First, the government allow actuarial deficit in their employee pension fund. For a company it is like borrowing money from their employee retirement fund. But when things worsen, usually they will put incentive for the older to take their pension earlier and it will increase the actuarial deficit of the fund. More and more employee get fired with less and less generous plan. Finally when it goes bankrupt the remaining employees that have survived this stage find out that the pension fund is way lower than expected. The pension fund deficit should be paid from the assets of the company, but check this: in our beautiful country, creditor have priority over them if anything remain. It happened to my father, and after 25 years of service he got close to nothing.
Another trick is to sell an entire department to a sub contractor company and transfer the pension fund. Let say it is an IT department of a big Canadian bank. Then the new sub contractor company decide to not recognize your previous years, then you have to fight in court may years to finally only get a fraction of what you should have due to lawyers fees. It happened to the father of a friend. They try that because not everybody wants to fight and they have a chance to settle for less because they know the lawyers cost and the long time it takes to get in court in canada.
There always some tricks to steel your pension. I don’t trust defined benefit pension.
That’s actually a really good point. Leaving it with a company means that an unscrupulous CEO might plunder it. So that’s another reason for the tin foil hat crowd.
There are many protections, regulations etc in Canada that protect against both the underfunding and raiding of DB pension plans. It’s important to vote in federal and provincial elections for political leaders that commit to keep such protections in place.
I totally agree with you.
I am an actuary. In my first job out of university, I was pricing underfunded pension for GM employees. GM closed many factories in Canada. They offer employers the option of taking a commuted value of underfunded pension, or take a pension that is only 50%-70% of the original promised amount. GM ask all the Canadian major life insurers to quote on these employees life. Then the employer purchases the lowest price life annuity for each employee.
My co-workers and I all prefer Defined Contribution plans. Employee get match-up amount, then invest in a portfolio with age-appropriate risk until retirement. You are guaranteed to get the total account value in a DC plan.
In our current market, DC plan return is much higher than DB plan. DB plans are required to hold a high amount of bonds and other fixed income securities. In current prolonged low interest environment, the return is very low.
I do have a defined pension offered by my company. They said I cannot withdraw the total amount. They can give me about 1/3 of the total.
The rest must be placed at the bank and I won’t be able to withdraw it before I turn 65…
Maybe a Quebec rule?
Huh never heard that rule before…
A very timely article for me. The value of my DC pension from my old company doubled recently. My jaw hit the floor when I saw the new commuted value. I immediately set up a LIRA and transferred the cash. I thought there was some sort of mistake but I wasn’t hanging around to find out!! Now it all makes sense
Good article! Despite the fact that I work(ed) for a legacy company with DB pensions, none of my colleagues seem to know how they work if you don’t stay with the company until retirement.
My employer even offers an online “retirement calculator,” to see what kind of income to expect after retirement. It lets you tweak the dates to any time you want, so I’m able to see what I’d get if I were to “retire,” say, at the end of the current month. It shows a smaller figure that would be paid unlocked and a larger one that would go into a LIRA. In my case it’s a low six figure payout after 12 years working for the company. We’re not talking FI money by a long shot, but left invested for another decade or two it would generate some decent walking-around money.
What I haven’t yet been able to determine is what exactly my options are with the money in my LIRA. Can I transfer it over to my Questrade account and invest it like with my TFSA and RRSP? If so, that would be one more solid reason to take the commuted value and run. I definitely think that leaving the money with the company for another 2 or 3 decades until I’m retirement age would be a risk.
Another reason to take the lump sum vs waiting for retirement monthly payments: if you die, the monthly payments stop or are halved (in the case of a surviving spouse). Once it’s in a LIRA, the money belongs to you/your estate and the employer can no longer touch it. If you’re in a family that likes to leave behind a legacy for the next generation, that’s a big difference.
Best view i have ever seen !