If your employer provides you with a defined benefit (DB) pension consider yourself lucky. According a 2009 study by Statistics Canada, fewer Canadian employees are covered by DB plans today. In 1991 41 per cent of Canadians were covered by DB, while in 2006 only 30 per cent of employees were covered. If you have a DB plan you’ve probably heard of the commuted value (CV), but do you really understand it? Let’s explore the CV and the various options available to you if you terminate your employment.
What is the commuted value?
The CV is a lump sum payment representing the present value of a member’s accrued pension. In layman’s terms, the CV represents how much money you would have to invest today to pay your future monthly pension. The CV goes by many names: transfer value, lump sum value, and actuarial present value.
Here is the basic formula for calculating the CV in a DB pension:
Your monthly accrued pension times 12 times the annuity factor.
While your monthly pension is easy to figure out (you can check on your annual pension statement), the annuity factor is very complicated – it’s based on the interest rate in effect, the age of the employee and various actuarial assumptions. The CV isn’t just something you can calculate yourself – you’ll need to speak with your employer or pension administrator to determine it.
What affects the value of my commuted value?
Besides your accrued pension, two of the major factors that determine your CV are your age and the interest rates currently in effect. There is a direct relationship between your age and the CV: the older you are, the higher the CV (even for a younger employee with the same accrued pension as an older worker). The logic behind this involves the time value of money. While the younger employee has more time to invest the money and realize the power of compound interest, the older employee is closer to retirement and thus has less time to invest the lump sum.
Besides your age, the interest rates currently in effect have an impact on the CV. There is an indirect relationship between the CV and interest rates: the higher the interest rates the lower the CV and vice-versa. This again has to do with time value of money – if you were to invest a lower amount you would need a higher interest rate to end up with the same retirement savings as investing a higher amount with a lower interest rate. Unfortunately you don’t have any control over interest rates, but it’s handy to know in case you decide to terminate your employment and transfer your CV.
Deferred Pension or Commuted Value?
Employees who leave their job prior to retirement are faced with a tough decision: should they elect a deferred pension or the CV? Before making this important financial decision it’s a good idea to consult a financial advisor since either decision can have a major financial impact on your retirement. Both options have their risks and rewards.
With a deferred pension you essentially leave your accrued pension with your employer until you are eligible for retirement; this can be a good thing since your pension is safe with your employer and will be paid out as a monthly pension when you opt to retire. However, some disadvantages are that your pension won’t grow and your money remains with your employer, so it could be at risk if something were to happen to your employer.
The other option is transferring the commuted value to a locked-in RRSP or retirement vehicle. The major advantage is the CV provides greater financial control over your retirement savings. You can invest your money and realize a decent return. Unfortunately there’s a risk – since you’re investing your retirement savings they aren’t guaranteed, so you could potentially lose a substantial amount of your retirement nest egg. Another disadvantage may be that employees who elect the CV won’t be eligible for post-retirement benefits, such as health and dental coverage (although most employers are doing away with them to save on costs).
Hopefully you’ve gained a better understanding of the CV. As I’ve mentioned, it’s very complicated to calculate and a very major financial decision whether to terminate your employment and take the CV or take a deferred pension. Be sure to think long and carefully about it and consult your financial advisor.
About the Author: Sean Cooper is a single, 20-something year old, first time home buyer located in Toronto. He has experience in the financial sector as a Pension Analyst, RESP administrator and Income Tax Preparer. He holds a Bachelor of Commerce in business management from Ryerson University.