As Canadians approach retirement, one of the most important decisions they face is how to receive their pension. For many, there is an option to either keep their pension in a Defined Benefit (DB) plan, which pays out regular income over time, or to take a lump sum payment. This lump sum represents the total value of your pension, which you can then invest, manage, or use as you see fit.
Taking your pension as a lump sum can be an attractive option, offering more control over your retirement savings and the potential for growth. However, it’s important to weigh the benefits against the risks to determine whether this approach is right for you.
What Does It Mean to Take Your Pension as a Lump Sum?
A lump sum pension payment is when you choose to withdraw the entire commuted value of your pension in one go, rather than receiving regular payments over time from your employer’s DB plan. This commuted value is a calculation of how much your pension is worth in today’s dollars, based on factors like your age, life expectancy, and expected future pension payments.
Once you take the lump sum, it becomes your responsibility to manage and invest the funds. Some retirees use the lump sum to create a personalized retirement strategy, while others invest it in products like annuities, RRSPs, or RRIFs.
How the Commuted Value is Calculated
The commuted value represents the present value of the future pension payments you would have received if you stayed in the pension plan. Actuaries calculate this value based on several factors, including:
- Your age & gender: Younger retirees, and women, often have higher commuted values, as the pension needs to last longer.
- Interest rates: Lower interest rates usually lead to higher commuted values, as it costs more to provide the same level of income.
- Life expectancy: The longer you are expected to live, the more valuable the pension.
- Pension payments: The basis of the calculation is how much your pension promises to pay you.
- Marital status: If you have a spouse or partner, the pension has to pay them til death too, often at a lower amount.
The result is a lump sum amount that represents the total value of the lifetime pension payments you would have received. It’s this amount that you can take and invest yourself. We will help you with that. We’re your quarterback.
Why Take a Lump Sum Pension?
There are several reasons why Canadians may choose to take their pension as a lump sum rather than staying in the pension plan. Let’s explore some of the key benefits of opting for a lump sum payout.
1. More Control Over Your Retirement Savings
One of the main advantages of taking a lump sum is that it gives you full control over your retirement savings. Instead of being locked into a fixed monthly payment, you can decide how to invest the money and how much to withdraw each year.
This flexibility allows you to tailor your retirement income to your needs, which can be especially beneficial if your financial situation changes over time. For example, you can adjust your withdrawals based on your spending needs, or you can take larger withdrawals in the early years of retirement when you want to travel or make large purchases.
2. Potential for Investment Growth
By taking your pension as a lump sum, you have the opportunity to invest the funds and potentially grow your retirement savings. If your investments perform well, the value of your lump sum could increase, providing you with a larger pool of money to draw from over the course of your retirement.
Many retirees choose to invest their lump sum in stocks, mutual funds, ETFs, or bonds to seek higher returns. While this comes with market risk, it also offers the potential for your money to grow more than it would if you left it in a fixed pension plan.
3. Flexibility in Tax Planning
When you stay in a DB pension plan, the payments you receive are fully taxable as regular income. With a lump sum, you have more control over how and when you withdraw the money, allowing you to manage your tax liability more effectively.
For example, you could withdraw smaller amounts each year to stay in a lower tax bracket or take larger withdrawals when your income is lower to minimize your tax burden. This flexibility can make a significant difference in how much tax you pay over the course of your retirement.
4. Protection from Employer Insolvency
Another advantage of taking a lump sum is that it protects you from the risk of employer insolvency. While most pension plans are well-funded, there’s always a chance that your employer could face financial difficulties or go bankrupt. In such cases, retirees may see their pensions reduced or even eliminated.
By taking a lump sum, you remove the risk of your pension being tied to your employer’s financial health. Once the money is in your hands, it’s no longer subject to the company’s pension plan, and you have control over how it’s managed.
5. Potential for Legacy Planning
If leaving a financial legacy for your family is important to you, a lump sum pension provides more options for estate planning. With a DB pension, your payments typically stop after you and your spouse pass away, leaving nothing to be passed on to your heirs.
By taking a lump sum, you can invest the money and ensure that any remaining balance is part of your estate, which can be passed on to your children or other beneficiaries.
Risks and Drawbacks of Taking a Lump Sum
While taking your pension as a lump sum has its advantages, it also comes with risks that you need to carefully consider. Here are some potential downsides to taking a lump sum payout.
1. Investment Risk
One of the biggest risks of taking a lump sum is the investment risk you’ll face. When your pension is in a DB plan, the responsibility for making sure the money lasts rests with the pension provider. They handle the investments and make sure the funds are there to pay you for life.
When you take a lump sum, the investment risk shifts to you. You’ll need to manage the money yourself, and if your investments perform poorly, you could run out of money in retirement. This is especially true if you withdraw too much too quickly or if you encounter a market downturn early in retirement.
2. Longevity Risk
Taking a lump sum means you’ll be responsible for making sure your money lasts for the rest of your life. This introduces longevity risk, which is the risk of outliving your savings.
If you live longer than expected or if your expenses are higher than anticipated, you could find yourself with a depleted retirement fund. On the other hand, if you stay in the pension plan, you’ll receive guaranteed payments for life, removing the risk of running out of money.
3. Tax Considerations
While taking a lump sum provides more flexibility in tax planning, it also comes with immediate tax implications. If you take the entire lump sum as cash, the portion that exceeds your RRSP contribution limit will be subject to income tax in the year it’s received. This could result in a significant tax bill. Look at our video: Maximum Transfer Value (MTV). Any money paid out beyond this limit, less any put into your RRSP, will be taxable. This is normally detailed on your DB pension statement.
However, you can reduce this impact by rolling the lump sum into tax-deferred accounts like an RRSP or LIRA. This allows you to avoid immediate taxation on some or all, and continue deferring taxes until you withdraw the funds in retirement.
4. No Inflation Protection
Some DB pensions include a level of inflation protection, with payments increasing each year based on the Consumer Price Index (CPI). This helps ensure that your pension keeps pace with rising costs. Government pension are usually inflation protected.
When you take a lump sum, you lose this built-in protection. If your investments don’t keep up with inflation, you may find that your purchasing power decreases over time, even if the nominal value of your savings remains the same.
What to Do With a Lump Sum Pension Payment
If you decide to take your pension as a lump sum, the next step is figuring out how to manage and invest the money to ensure that it lasts throughout your retirement. Here are a few options to consider. We can help with this.
1. Transfer to an RRSP or LIRA
One of the most tax-efficient ways to handle a lump sum is to transfer it into an RRSP or a Locked-In Retirement Account (LIRA). Both of these accounts allow your money to grow tax-deferred, meaning you won’t pay taxes on the funds until you start making withdrawals.
- RRSP: If you have enough contribution room, you can transfer the lump sum into your RRSP. This keeps the money growing tax-free until you’re ready to withdraw it in retirement.
- LIRA: A LIRA works similarly to an RRSP but is specifically designed for pension funds. The money in a LIRA is locked in until you reach retirement age, usually age 55, ensuring that it’s used for its intended purpose—retirement income.
2. Purchase an Annuity: a Copycat pension
Another option is to use the lump sum to purchase an annuity, also called a copycat pens which provides guaranteed income for life. This is the same as your DB pension but allows your to draw that same, identical pension from a Cdn insurer. You thereby remove any danger of your employer plan becoming insolvent.
For example, you could choose an inflation-indexed annuity, which increases payments over time to keep pace with rising costs, or a joint-life annuity, which continues to pay income to your spouse if you pass away first.
The copycat pension must pay the same as your company pension. CRA mandate that. Plus you might receive a cash surplus.
3. Invest in a Diversified Portfolio
If you’re comfortable managing your investments, you can invest the lump sum in a diversified portfolio of stocks, bonds, and other assets. This approach offers the potential for growth, but it also comes with market risk.
The key to success with this strategy is ensuring that your portfolio is well-diversified and aligned with your risk tolerance and time horizon. Many retirees use a mix of low-risk bonds for stability and stocks for growth, adjusting the balance as they age.
4. Open a RRIF
Once you’ve transferred your lump sum into an RRSP or LIRA, you’ll need to convert it into a Registered Retirement Income Fund (RRIF) when you reach age 71. A RRIF allows you to continue growing your investments while also providing regular income in retirement.
The key benefit of a RRIF is the flexibility—you can adjust your withdrawals each year based on your needs. However, keep in mind that the minimum withdrawal requirements increase as you age, so you’ll need to plan carefully to ensure that your savings last.
Lump Sum vs. Staying in the Pension Plan: Key Considerations
Deciding whether to take your pension as a lump sum or stay in the pension plan depends on a variety of factors, including your risk tolerance, financial goals, and personal situation. Here are a few key considerations to help you make the right choice.
1. Are You Comfortable Managing Investments?
If you’re confident in your ability to manage investments and are comfortable taking on market risk, a lump sum may be a good option. It gives you the flexibility to invest the money as you see fit and the potential to grow your retirement savings over time.
On the other hand, if you prefer guaranteed income and don’t want to worry about managing investments, staying in the pension plan may be the better choice.
2. How Long Do You Expect to Live? Are you healthy?
Your life expectancy plays a significant role in this decision. If you expect to live a long life, staying in the pension plan ensures that you won’t run out of money, as the payments are guaranteed for life.
If you have health concerns or believe your life expectancy is shorter, taking a lump sum might allow you to access more of your money sooner and provide more financial flexibility.
3. Do You Need More Flexibility?
If you want more control over how and when you access your money, a lump sum provides more flexibility than a fixed pension. This can be especially important if you have large expenses early in retirement or if you want to leave a financial legacy for your family.
4. Are You Concerned About Employer Stability?
If you’re worried about your employer’s financial stability or the health of the pension plan, taking a lump sum allows you to protect your retirement savings from the risk of employer insolvency.
Key Takeaway
Taking your pension as a lump sum can be a smart move for Canadians who want more control over their retirement savings and the potential for growth. It provides flexibility in how and when you access your money, allows for tax planning, and protects you from employer insolvency.
That said, a lump sum comes with risks, including investment risk and longevity risk, and it’s essential to have a clear plan for how you’ll manage the money to ensure it lasts throughout your retirement.
Before making a decision, it’s important to consult with a financial advisor who can help you weigh the pros and cons and determine whether a lump sum is the right choice for your retirement plan. Contact us at Pension Solutions Canada, our services are at no cost to you!
