Take the Pension or Take the Money: The Commuted Value Decision

It arrives in an envelope with a deadline in it. You have left a job with a defined benefit pension, and the administrator has set out two options: a pension payable for life starting at some future date, or a lump sum transfer value now. The lump sum is almost always a larger number than anything you have seen on a statement, and the deadline is usually measured in weeks. Most people make this decision once in their lives, under time pressure, with no prior experience of the question, and often with somebody nearby who has strong views. And there is no general right answer. The pension and the transfer are not a safe option and a risky one; they are two different risks, and which one a household should prefer depends on facts about that household rather than on arithmetic anybody can do in the abstract. This article explains what is actually being traded, what the tax rules do to the number in the letter, and the three questions that decide it.

What is actually being traded

On one side is a pension: an income paid for as long as you live, usually with a survivor benefit for a spouse, sometimes indexed to inflation and sometimes not. It does not depend on markets, it does not depend on your investment decisions, and it does not run out. What it does depend on is the plan continuing to be able to pay, which is a real consideration and a different one from market risk.

On the other side is a transfer value: a sum of money calculated today to be the actuarial equivalent of that future income stream. Once transferred it is yours to invest, it can be left to your estate if you die early, and it can be drawn on flexibly within the locking rules. What it does not do is guarantee anything. If it is invested poorly, or drawn down too fast, or if you live much longer than the calculation assumed, it can run out. The pension cannot.

The clean way to state it: the pension transfers longevity risk and investment risk to the plan and keeps you dependent on it. The transfer takes both risks back and makes you independent of it. Neither is safe in every direction, and anyone describing one of them as the safe choice has not named which risk they are ignoring.

The number in the letter is not the number you receive

This is the part that surprises people most and it is worth understanding before the deadline. A commuted value cannot simply be moved into a registered account in full. Tax legislation limits how much of it can be transferred to a locked-in account on a tax deferred basis, and that limit is calculated by formula rather than being a matter of choice.

The portion above the limit is generally paid out in cash, and it is taxable in the year it is received. Because a commuted value is usually a large number, that taxable portion can arrive in a single year at the highest rates the person will face, and it can affect income tested amounts in the same year.

Whether any of the cash portion can be sheltered depends on whether you have RRSP room available, which is a question about your own contribution history rather than about the pension. Somebody with substantial unused room has a materially different outcome from somebody with none, and this is one of the few places where knowing your room in advance changes a decision rather than just a filing.

The locked-in portion, meanwhile, is locked. It goes into an account governed by the pension legislation of the plan’s jurisdiction, and it carries the rules set out in the companion article, including a maximum withdrawal once income begins. It is not a flexible pot of money.

Why the number moves, and what that means

A commuted value is the present value of a future income stream, and present values move inversely with the interest rates used to calculate them. When the rates used are low, it takes more money today to fund the same future income, so the transfer value is larger. When they are higher, it takes less, so the transfer value is smaller.

Two things follow. The value quoted to you is a fact about the calculation date rather than about the pension, and the same pension can produce quite different transfer values in different years. And a large transfer value is not evidence that transferring is the better choice: the same conditions that made the number large also mean the money must be invested in the same environment.

This is not a reason to try to time the decision, which is rarely possible given the deadlines involved. It is a reason not to treat the size of the number as an argument in itself, which is exactly how it tends to be received.

The three questions that decide it

The first is longevity, and it is uncomfortable and unavoidable. The pension is insurance against living a long time. If you have reason to expect a long life, the pension is worth more than the arithmetic of an average suggests. If there is a serious health issue, the transfer value keeps for an estate what a pension would not, subject to whatever survivor benefit the plan provides. That survivor benefit needs reading, because a pension with a strong survivor provision is a different thing from one without.

The second is what else is guaranteed. A household that will already have substantial indexed lifetime income, from public pensions and perhaps another plan, has less need to buy more of the same and more room to accept the risk of the transfer. A household whose only secure income would be the public pensions is in a different position, and the base of guaranteed income is usually the first thing to protect.

The third is honest and rarely asked out loud: would you actually manage the money the way the comparison assumes. The projections that favour transferring assume a return achieved over decades, a drawdown followed with discipline, and no panic in a bad year. Some people do that. Many do not, and a plan that requires behaviour a person will not sustain is not a plan. There is no shame in the answer being no; there is real cost in pretending it is yes.

Two secondary questions belong in the same conversation. Is the pension indexed, because an unindexed pension loses purchasing power over a long retirement and that changes the comparison substantially. And what is the financial position of the plan and the sponsor, which is a legitimate question to ask and to have answered with information rather than with rumour.

The options between the two

The choice is often presented as binary and sometimes is not. Some plans allow a partial transfer, or offer several pension forms, and where they do the middle ground is worth examining rather than ignoring.

Where a full transfer is taken, part of the money can be used to buy guaranteed lifetime income, which reproduces some of what the pension provided while keeping the rest flexible. That is a genuine option and it should be described honestly: it costs what it costs, and it is bought in the same interest rate environment that produced the transfer value.

And the pension form itself is a decision within the decision. A higher payment with a smaller survivor benefit, a lower payment with a larger one, a guarantee period, an indexed option where offered: these choices are usually made once, at the start, and cannot be revisited. They deserve the same attention as the transfer question and typically get far less.

How to approach it, given the deadline

Get the full package from the administrator, not the summary. That means the transfer value, the deadline, the pension amounts under each available form, the survivor provisions, whether it is indexed, and the split between what can go to a locked-in account and what must be paid in cash.

Establish your own RRSP room before deciding, because it determines what happens to the cash portion and it is a number you can get in an afternoon.

Model the household’s full retirement income both ways, on the same page, including public pensions and their timing. The comparison that matters is not pension against lump sum; it is total household income and its security under each choice.

And take it to a qualified tax professional along with a licensed insurance professional before the deadline rather than after. This is a decision made once, it cannot be reversed, and the deadline is short enough that starting in the last week is how people end up choosing by default.

Who is in the room when this is decided

A decision this size attracts opinions, and opinions arrive faster than information does. A colleague who took the transfer and is pleased. A brother in law who took the pension and is pleased. Neither of them has your health, your household or your other income.

The professional side deserves a plainer question than it usually gets: how is the person helping you paid, and does that change with the choice you make. Somebody compensated on money that is invested has an interest in one of these two answers that somebody comparing them on paper does not. That is not an accusation, it is a fact about incentives, and it is handled by asking out loud rather than guessing.

The useful test of any help you receive is whether it argues both sides, and whether it read the plan documents before saying anything at all.

When a relationship ends before the election is made

A pension earned during a marriage or a qualifying common law relationship is generally family property, and a separation can require part of its value to be divided. The rules are provincial, the valuation follows a prescribed method rather than an estimate, and the administrator acts only on documents in the form the legislation requires.

What matters here is sequence. A division still unsettled changes what is actually yours to transfer or to draw as income, so the family law question is answered first and this one second. That order belongs with a lawyer or notary before anything is elected.

Frequently Asked Questions

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Read Locked-In Accounts for what the transferred money becomes, When to Start Your CPP or QPP Pension for the other guaranteed income in the household, and RRSP Contribution Room for the room that decides what happens to the cash portion. The Wealth Creation guide sets out the whole picture.