The pension decision: to commute or not to commute?

When leaving an employer, many people are faced with the decision to leave their pension entitlements on a paid-up basis with their former employer or to move it to a personal locked-in retirement savings plan (LRSP) or locked-­in retirement account (LIRA).

If you belong to a defined contribution or money purchase plan, the decision is relatively easy. The full market value of your entitlement can be transferred to a personal LIRA. The advantage of this is that it will provide you with full and direct access to a more diverse range of investment options, which are typically more limited in the company pension plan.

However, if you belong to a defined benefit pension plan, the transfer to a LIRA isn’t as straightforward. This article explains the most important elements to help you make the most of the benefits you’re entitled to.

In many cases, the maximum transfer value imposed by the Income Tax Act will prohibit the full value of your entitlement from being transferred to a LIRA.

Regulation 8517 of the Act provides a factor, based on age, that’s multiplied by your annual benefit. Because this factor doesn’t consider the value of additional benefits, such as indexing or early retirement features, the maximum 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. You can reduce the impact if you have available registered retirement savings plan (RRSP) contribution room and use some of the taxable amount to make a contribution. However, many people in this situation don’t 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). A pension adjustment reversal (PAR) may be available under certain circumstances, which is discussed further in the pension adjustment reversal section below.

Maximum transfer values (factor times annual benefit)

Maximum transfer value example

Assume you’ve left your current employer at age 50, and your statement indicates that the commuted value of your benefit is $350,000 and your annual benefit is $27,000, payable at age 65, indexed at 2% each year. If you choose to transfer the commuted value to a personal LIRA, under the Income Tax Act, the maximum allowed as a direct transfer will be $253,800 (27,000 x the factor of 9.4). The balance of $96,200 will be paid to you as a taxable lump sum. At a 45% tax rate, you would have an after-tax balance of $52,910.

If you invest both these amounts, the $253,800 in a LIRA and the after-tax lump sum of $52,910 in a taxable account for 15 years, you’ll need an annual rate of return of 2.28% to have the $430,384¹ needed at age 65 to purchase the same $27,000 indexed pension income. Alternatively, if you decide to spend the $52,910 and invest the $253,800, you’d need an annual rate of return of 3.58%.

In this example, a person may decide that the transfer is still a good decision despite the large tax bill. This won’t always be the case, however. Often when the comparison is between a pension payable immediately, such as taking early retirement from the company, and trying to duplicate the same income by commuting, the upfront tax hit on the non-transferrable portion will make the company retirement plan almost impossible to beat.

It’ll be important for you to use numbers that reflect your own situation before determining the feasibility of transferring the commuted amount. Remember also, if you commute, your employer will no longer be assuming the investment risk; you will.

Indexed benefits can add substantially to the amount of dollars needed at retirement to purchase the same pension. This is especially true if there’s indexing of your benefits prior to retirement as well as after retirement. The previous example uses a 2% indexing factor after retirement. If this income was indexed at 1.5% during the 15 years prior to your income date, the amount of annual pension to be purchased at age 65 would increase by 25% to $33,756 for a cost of approximately $536,753 — 125% of the original amount. The new required annual rate of return would be 3.80% if all available dollars are invested, and 5.12% if only the locked-in portion is invested.

Benefits such as health and dental are sometimes offered to employees who are considered to be retired. In some cases, the criteria depend on whether the pension money is transferred. If you’ll lose retiree benefits because you take the commuted value and are, therefore, considered a terminated employee rather than a retired employee, then the additional cost of private coverage will also need to be factored in.

Your former employer’s financial stability can also be a consideration. If you’re not sure that your employer will still exist or be financially able to meet its pension promises over the long term, you may decide that you’d be better off taking the lump sum now to avoid any uncertainty with respect to your retirement income in the future.

If you’re earning benefits governed by Ontario pension laws, there’s some protection provided to employees of insolvent employers through the Pension Benefits Guarantee Fund. However, the maximum benefit is capped at $1,500 of income per month. There’s no protection in any other province.

If your spouse is in a lower tax bracket and you plan to start receiving retirement income before age 65, the pension income received directly from a company pension plan can be split at any age (except in the province of Quebec, where you must be 65 to split pension income for provincial tax purposes). If you commute the pension and draw income from a life income fund (LIF) you’ll have to wait until age 65 to take advantage of the tax savings available with pension income splitting.

A PAR is calculated if you decide to transfer the commuted value of your pension to a LIRA. It’s not calculated if you leave the benefits with your 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. A PAR restores RRSP room equal to that difference. This restored RRSP room allows you to avoid taxes on some or all of the lump-sum amount not normally transferable under the maximum transfer rules. If you’re eligible to receive a PAR, your former employer will advise you of the amount.

Some provinces and federally regulated plans allow a portion of your benefit to be unlocked (New Brunswick, up to 25%; Ontario, Manitoba, Alberta, and federal, up to 50%; and Saskatchewan, up to 100%). However, this isn’t available if you don’t commute. For more information, see Registered Retirement Income — The facts.

As you can see, there are many factors to be considered when deciding whether to take a commuted value or to leave the pension on a paid-up basis with a former employer. This article discusses the financial aspect of it, but not all factors in your decision will be financially based. Depending on the terms of your termination of employment, you may also have emotional reasons for severing all ties with a former employer.

1 Based on annuity rates in effect January 2024.