This article appears in the November issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.
Chances are some of your clients will change jobs at least once. And if those jobs involve pensions, clients will need to make important decisions.
“There are a lot of misunderstandings about how pension plans function, so these decisions are very hard for people to evaluate on their own,” said Aurèle Courcelles, assistant vice-president of tax and estate planning with IG Wealth Management in Winnipeg.
Employees who leave a job at which they contributed to a defined-contribution (DC) or a defined-benefit (DB) pension plan have four main options:
Option 1: Leave the pension with the previous employer
Retirement options for a DC plan member may include one or more of the following: remain in the plan and receive periodic withdrawals directly from the plan, transfer to a locked-in retirement account or life income fund with a financial institution, or annuitize the plan with an insurer and receive lifetime payouts.
DB plan members who do not yet qualify to retire and begin collecting benefits usually can stay in the plan and receive their benefits at a later date, based on their salary and years of service with the original employer.
Even at reduced levels, Courcelles said, many clients still appreciate the stability and lifelong nature of deferred DB plan payments, which in many cases are indexed to inflation.
Remaining in a DB plan comes with mortality risk: the client and their surviving spouse might not live long enough to collect the pension’s commuted value, Courcelles said.
Option 2: Transfer to the new employer’s plan
Assuming the client’s new and former workplaces operate under the same legislative framework for pensions, DC plan members may be able to transfer their savings to an account with their new employer’s plan. Although consolidating funds in this way is more convenient, doing so may mean the client remains limited to the new provider’s investment options, said Jaclyn Cecereu, a financial planner and investment advisor with PWL Capital Inc. in Ottawa.
Transfers between DB pensions are possible in theory but relatively rare, due to the dwindling number of employer-sponsored DB plans. Even if a client moves to a workplace with a DB plan, their ability to import some or all of the commuted value from their old plan will depend on the local pension legislation and the specific rules of the recipient plan.
Option 3: Annuitize
Until recently, low interest rates have largely taken life annuities off the table for terminated employees looking to redeploy their DC pension assets, said Marlene Buxton, principal with Buxton Financial in Toronto. But recent rate hikes are beginning to make annuities look more attractive.
Departing DB plan members worried their plan sponsor could become insolvent may be able to use a special life insurance product known as a “copycat annuity,” which qualifies for a tax-deferred transfer of the pension’s commuted value. The annuity must mirror the benefits the member would have been entitled to had they stayed in the plan.
In cases in which the annuity costs less than the commuted value, clients will receive a taxable cash payment to make up the difference, said Lea Koiv, a tax, pension and retirement planning specialist in Toronto.
Option 4: Cash out
DC plan members can take control of their investment decisions by transferring the savings in their pension plan to a registered account such as a locked-in retirement account (LIRA) without any tax consequences.
“Usually, [your client] would open a LIRA at the same institution where they have their other retirement accounts, like their TFSA or RRSP, so it can be integrated into their financial plan,” Cecereu said.
However, rising interest rates have had the effect of depressing valuations.
If the commuted value of the client’s DB pension exceeds the maximum transfer value set by the Income Tax Act, excess funds must be taken as a lump sum and taxed as regular income, subject to an RRSP deduction if the client has contribution room.
Making the decision
“Honestly, there’s no magic formula to determine the right way forward,” said Lesley Poole, president of Next Chapter, an independent financial planning firm in Gananoque, Ont. “You know the commuted value and life expectancy. From there on, you’re weighing other factors.”
Here are some of the factors to consider when helping clients decide the fate of their pension assets after leaving their job:
Risk profile: The idea of managing investments is as thrilling to some clients as it is frightening to others.
Poole likes to probe her more bullish clients to test whether their risk tolerance matches their optimism regarding return generation. She gained firsthand experience about investment risk when she withdrew funds from her bank-sponsored pension in 2008, just in time for the market to drop by a third.
“I’m a pretty tolerant investor, but that was pretty scary,” Poole said. “I rode it out and had plenty of time to recover, but not everybody could deal with that.”
Broader finances: The size and nature of a client’s family assets and their other sources of retirement income, including Canada Pension Plan, old age security, RRSPs and TFSAs, will help determine how dependent the client will be on their workplace pension.
“If you have two partners in the household, each with a DB pension,” Buxton said, “it might make sense for one to keep it and one to commute, so that they get some more flexibility in terms of their taxation and cash flow.”
Age: Younger clients with fewer pension assets are generally better off consolidating their balances in their own LIRA to ensure the assets are not lost or forgotten in years to come, Buxton said. That’s assuming the client acts quickly enough, as some plans have deadlines for transferring to a LIRA (usually a few months after departure).
Sequence-of-return and longevity risks are important for older clients, according to Koiv. She uses her client meetings to stress the value of the lifelong income provided by DB pensions and annuities.
Health: Eligibility for supplementary benefits, such as life insurance and drug and dental coverage, are frequently overlooked by departing plan members, Courcelles said. Having to pay for these benefits out of pocket “can be a significant burden if [the departing employee] hasn’t planned for it,” he said.
Clients with health issues that could shorten their life expectancy can decide to commute their DB pension in order to maximize the money in their estate.
Institutional solvency: Clients should check pension solvency disclosures to get an idea of the health of their DB plan. They should be advised that these statements can fluctuate significantly from year to year because of the variables involved in calculating the cost of future obligations.
“It doesn’t happen often that a corporation goes bankrupt and the employees don’t get the full value of their pension,” Courcelles said. “But it is a risk. If you’re a government employee, you’re not going to be too worried.”