Individuals with a Defined Benefit Pension Plan (DBPP) often face a tough decision when they leave their place of employment – whether to keep a portion of their pension plan or take the commuted value. The commuted value of your pension is a single lump sum payment that is, in theory, the value of your pension at the time that you take it. Since a pension is a stream of lifetime payments, the employee may have a choice between a lump sum payment (commuted value) and an annual income in retirement (pension).
Taking the commuted value of your pension allows you to invest the money in a Locked-in Retirement Account (LIRA) which gives you full control over the investment decisions.
- Growth Potential
Depending on how far away from retirement you are and or how well your investments are managed, taking the commuted value of the pension and investing it successfully may provide you with greater income potential than a fixed pension would.
- No Guarantee
Taking the commuted value of a pension removes any guaranteed income stream. You will be taking responsibility for the management of your pension money. In your hands, the money is exposed to a variety of risks, including investment and possibly inflation risk, both of which could compromise your retirement income.
The accessibility aspect of taking the commuted value can be a mixed bag. For the disciplined investor, having this money accessible can provide the opportunity to occasionally take less or more income depending on market fluctuations and specific circumstances. However, accessibility could be a disadvantage for the people who might be tempted to dip into their pension money to fund short term goals, thereby creating cash flow problems down the road.
By keeping the pension, you can predict exactly how much money you will receive for the remainder of your life and this can bring about great peace of mind and make retirement planning a lot easier. Research shows that retirees with lifelong pensions tend to maintain their level of life satisfaction during retirement, whereas those without a pension tend to become less satisfied over time.
Keeping the pension takes the work out of maintaining an investment account and making investment decisions.
- No Residual Amount Leftover
While some pensions have a spousal benefit that is equal to a portion of the pension payments, keeping your pension means there is no money left over for your estate after your death. This means that once you die, if you were single or did not have a spousal benefit, your pension would cease. If you do have a spousal benefit, the pension would cease on the death of your spouse.
- Solvency Issues
Your pension could be compromised in the event the pension sponsor experiences financial difficulties.
The Bottom Line
Deciding between keeping a pension or its commuted value is a big decision that shouldn’t be taken lightly. A financial professional can help you understand your options and can explain the implications of both options.