Why We Took the Commuted Value of our Defined Benefit Pension

In the last few financial freedom updates, I talked a little about my spouse leaving her full-time work.  While there was a bit of financial juggling to do, there was one major decision that we had to make with regards to her pension. We had to decide on either leaving her defined benefit pension in place or taking the lump sum (commuted value) and investing it ourselves in a locked-in retirement account (LIRA).

Before making a decision on the defined benefit pension, about a year ago my wife also had a defined contribution pension that was transferred into a LIRA with Questrade.  Transferring that pension was an easy choice as the benefits during retirement were not defined but based on investment returns.  With the high MERs that the provider was charging, it was an easy choice to take the money and invest it myself.  We decided to invest in low-cost index ETFs for that amount.

What is a Defined Benefit Pension?

First for new readers out there, a defined benefit pension is typically offered by government employers and is considered a major benefit of working for the civil service.  In this type of pension, the requirement is that you work in government for 25-30 years, contribute a small portion of your salary towards the pension and in return, you get 60-70% of your working income during retirement (some pensions are even indexed to inflation).  It really is a great deal for employees willing to stick it out with the same employer for the long term.  More details about defined benefit pensions here.

The decision on whether or not to take the commuted value of a defined benefit pension is a bit more involved.  Mostly because the income provided during retirement is defined and for the most part, secure.  There is something about the certainty of regular recurring income that is enticing.

With any major decision like this, I like to review the pros and cons.  For a numbers guy like me, there were also a number of intangible and subjective points to consider.

The Pension Numbers

Monthly Income for Life

I will admit that the numbers made a big impact on my decision.  The pension statement showed at age 60 (about 22 years from now), my wife would be entitled to $7,700/year for life (not indexed to inflation).  While not a huge amount during retirement, it would be a nice guaranteed base income.   But also note that the $7,700/year includes the CPP bridge benefit. This means that the pension actually gets reduced at age 65, but CPP will kick in, so overall income should stay relatively the same.

The Commuted Value

When my wife left her job, she received some paperwork indicating her pension options.  This included:  leave the pension in place; transfer to a new pension (if applicable); or withdraw the commuted value of $54,500.

Due to the size of the commuted value, we had the option to transfer the full amount to a LIRA and avoid paying any taxes – at least until withdrawals begin in the future (55 is the minimum age in NL).

Comparing to an Annuity

A defined benefit pension is essentially the same as buying an annuity.  Both will give you income for life, but you lose the balance once you pass away (some pensions and annuities allow the spouse to get a portion of the benefit).

Using an online annuity calculator, a 60 year old female buying a registered annuity provides about $5,000/year income for every $100,000 purchased.  So to get an equivalent income during retirement, we would need to purchase about $150,000 worth of annuities to generate about $7,700/year income.

What rate of return would I need to turn $54,500 into $150,000 in 22 years (by age 60)? The compounded annual rate of return (CAGR) works out to be 4.71%.  The DIY return required is likely less than this because the pension benefit gets reduced @ age 65, but we will leave that complexity out of this analysis.

So now the question becomes, do I think that a diversified low-cost passive ETF portfolio can at least match 4.71%?  Historic long-term market returns show that returns will likely be higher than this. We also get the added benefit of choosing how much to withdraw from the portfolio and potentially, there is flexibility in how much money is left behind to the next generation.

The Intangibles

While the numbers show that long-term market returns support taking the commuted value of the pension, there are other intangible factors as well that added to our decision.  Some of these factors are specific to the NL pension.

  • Removed health benefits – Some pensions allow pensioners access to medical benefits, which is a huge benefit for an aging pensioner.  The NL government, however, has removed this benefit for those who do not retire with the government.  In other words, if you leave government before retirement age, you will not be eligible for medical benefits even if you keep the pension in place.
  • Control – If you didn’t know already, but when it comes to money, I tend to value control.  With the commuted value, I can choose what to invest in, the amount to withdraw during retirement, and even use a lump sum if needed.  Or, as mentioned above, we could leave a legacy for the next generation.  The idea of the money essentially disappearing after I pass does not settle well with me.

Final Thoughts

A few readers have asked about their pensions and what they should do with them.  I hope that this article helps in your own decision.  If we had a federal pension that was indexed to inflation and provided medical benefits, then we probably would have written an entirely different article.  In addition, if you aren’t comfortable with DIY investing, then leaving the pension intact is not a bad idea.

For me, it was a variety of factors that helped us ultimately make the decision to take the commuted value of the pension.  The main reasons being: we can probably generate a higher income stream from the commuted value with 22 years of compounding at a higher rate of return; we can control the withdrawal rate during retirement which provides flexibility; and, the money doesn’t go away after my wife passes.

Photo Credit:  Mine.  Yes, my art skills are equivalent to a 6-year-old.

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Frugal Trader

FT

FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.
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D&C
2 years ago

Hi FT! Thanks for the quick reply!
I think his main reason for wanting to take the commuted value is that he hates the idea that when he dies, the pension is gone. He has had some health issues in the past (luckily he is well now) and thus his outlook on things has changed. If he takes the commuted value, the money that he has put into it stays in the family.
As for the medical portion, he can be added to mine once he leaves and then if I leave teaching, we would have to make a decision on what to do I guess. I may not fully leave teaching, but instead work part time or sub. He also intends to keep working, but at something else following his retirement. He is pretty burnt out from his current job and would like to leave sooner rather than later. He is fit and active so he definitely won’t want to fully retire. I guess we will have to wait and see how the numbers work when the time comes and see if it makes sense for us. Thanks for your help and we’ll keep reading your blog!

D&C
2 years ago

HI FT. We just found your blog today and are excited. It’s so nice to have a fellow Newfoundlander who can offer advice on things like this. We are in the unique position that my partner can retire in 1. 5 years but I still have 17 years left. He works for the provincial government and I’m a teacher. The goal ideally for us to be both FI in 10 years. We are investing in ETFs using Quest Trade, reducing our expenses and taking on side hustles (in retirement) so we can spend quality time together and have similar schedules.
We are leaning toward my partner taking the commuted value of his pension. He would receive $33000 a year before taxes if he takes the pension. We have really no idea what he would get if he takes the commuted value at this point. We also have TFSAs and some money in RRSPs and rental properties. I also have an RDSP that I can draw from at 60 and if I deffer my pension, I can start receiving it at 62.
Do you think, given our circumstances (he’s 51 and I’m 36) that it would be a good idea to take the commuted value of his pension in an effort to be FI in 10 years? Thanks!

redd
2 years ago

Hi, Thanks for the post. It is really informative. I’m facing a similar situation myself and would like your opinion. The commuted value of my pension came up to be around 25% less than sum of my contributions and my employer contributions and I wonder if it is right?

Jaymee @ Smart Woman
3 years ago

This is just the article I was looking for! I’m facing the same decision shortly where I am planning to step back from my full-time position as a nurse and wondered what I should do with my pension.

I’m in favour of taking the commuted value because I think I can make it grow more than if I had left it sitting in my pension. I didn’t like the idea that the money would disappear after I die (never mind if I die early). And although the pension does transfer to a spouse after I die, because I’m a woman, I anticipate living longer than my future husband. I also like the idea of more control and possibly leaving unused money for the next generation.

I have had people telling me not to do this however… they told me it would be insane for me to give up my defined benefit pension – these people are other nurses and some financial advisors.

Jaymee @ Smart Woman
3 years ago
Reply to  Frugal Trader

Hey FT,

I should mention I live in Canada so I didn’t have to worry about accounting for my healthcare needs when I retire.

However I appreciate the insights you provided. I am sometimes impulsive in my decisions instead of taking the time to do my due diligence.

When the time comes and I give up my permanent position, I’ll receive a document from my pension outlining what my options are. I’ll have more info then to help me make a decision once I find out the commuted value (I’ve only worked for 4 years at my current job).

I do like the idea of keeping it as my fixed income/bond fund and then be more aggressive with my other accounts! Thanks for this suggestion :)

Jaymee

Confused
3 years ago

Hi, I’m having to face this situation myself and would like your opinion. The commuted value of my pension is $444,000, of which $90,000 would be taxed, if I took it out. It is a DB plan, which would pay $3200 a month, if I left it with my former employer. I don’t believe it’s indexed and there are no medical benefits attached. I would have 15 years to make the investment grow before drawing from the funds. Should I take it out? or leave it alone?

Lisa
3 years ago

Hello!

I am in AB and indeed vested after 2 years.

I will indeed wait for my statement to see what I will do then but I feel like I will take my own route to invest this money :-)

Thanks so much for this post!

Janna
2 years ago
Reply to  Lisa

Lisa, are you part of the federal Public Service Pension Plan? If so, you should be able to use online pension tools to get estimates on commuted value (or transfer value). The transfer value can only be calculated/estimated within 3 months of proposed departure date (due to fluctuating interest rates). Hope this helps.

Lisa
2 years ago
Reply to  Janna

Hey!

I am part of the Public Service Pension Plan (in AB) and their website is absolutely ridiculous. It’s not even up to date so the amount you have there is usually updated once a year or once every 2 years. (They actually sent us a statement from 2016 this year…)

The only option I have is the projection calculator.

Lisa
2 years ago
Reply to  Lisa

Hello!

Just wanted to let you know that I took the commuted value and now waiting for the transfer to my LIRA. I chose RBC because the easiest thing to do for me but I will probably end up transferring everything to Questrade or similar at some point.

Also for people who are interested, you can absolutely keep a LIRA and a RRSP when you go live in the US and become non resident. You won’t able to add any more money to your RRSP but the money will still grow :)

Lisa
3 years ago

Thanks so much for this post! I am actually in the exact same situation. Contributing to PSPP for last 4 years. I probably have around 60 K (my own contributions) and planning to leave later this year for a job in the US where I will be a permanent resident. So kinda planning to stay there for a while if I like it.

Questions for you:

– my employer matches 100% but I have never seen their contribution on my statements so does this mean you only get it if you keep your contributions in the same plan and then ultimately get both your contributions and your employer
‘S at 65?
that would mean that I don’t have 60 K but 120 K and it makes a big difference
– now, I had to deal with PSPP 2 years ago and their customer service is absolutely atrocious so I am having a hard time trusting them considering than I am only 30. It means leaving my contributions for the next 35 years and then hoping to get it back. I absolutely don’t trust them on this.
– knowing that I may leave for the US, is it a good idea to leave my money to PSPP?

What would you recommend?

Chris
3 years ago

Hey, just started reading your blog – awesome info here. An old co-worker of mine recently did the same thing with her DB pension. She had almost 30 years of service paid into it, and would have received about $5000/month in pensions but she took the commuted value only a few months before she could retire. She took home about $750,000 from the pension plan. I’d say it’s a great option if you’re comfortable with DIY investing or have a good adviser.

Mat
3 years ago

I did the exact same thing and my DB was considerably higher. I came to the exact same conclusion and for me it ended up even better. I had to transfer a max amount to a locked in RRSP which was about 128K. That alone at 5% would exceed the value of my DB assuming i had retired at 60. On top of that, because my commuted value was more, I received a significant cash payout of which i maxed out my RRSPs to reduce my taxes. Even after taxes, I came out like a bandit with significant cash today and enough in my rrsps to equal what I would have received. I spent hours going through the numbers and receive two independent opinions. It was a tough decision, but its been a year now and I look back and would make the decision 10 times out of 10.

Evan
3 years ago

Poor decision. You have simple done a reverse risk arb and placed the risk on your own shoulders instead of the company’s. You have determined the risk-free interest rate of the pension to be ~4.8% whereas the true risk free rate is much closer to 0%. If this is a government pension then you have truly handicapped yourself by 5% annually.

Bob Lin
3 years ago
Reply to  Evan

Evan, does the “poor decision” statement apply to the assumed rate of return of the decision to transfer out of the DB? Because I see more than just the amount of dollars playing a role in the decision, for example, if the couple dies after the DB’s guarantee period (typically 5, 10 or 15 years – the longer it is, the lower the monthly pension), then nothing will be going to their children or grandchildren, or perhaps even their favorite charity. The self-managed route should also provide some flexibility in how and when the money is utilized, whereas once you start drawing from the DB, that’s it for life.
Further, the Sears pensioner’s issue shows that DBs are not 100% guaranteed, perhaps they are to around 80% today, but lobbying by big business to relax such controls is relentless.