Retiring employees with defined benefit pension plans are often offered a choice between taking their pension in a lump sum (known as the commuted value) or receiving a monthly payment.
When faced with the decision there are both quantitative and qualitative factors to consider. With the monthly payment option you are guaranteed a pension payment until death with the option of a survivor benefit and potential indexing to inflation. If you select the lump sum option, the monthly pension is forfeited, and a calculation is made to determine the size of the lump sum.
The quantitative analysis involves many factors. Taking a commuted value in a low interest rate environment is more favourable than when interest rates are high. While the exact calculation is complicated, the lump sum is closely tied to current interest rates. When interest rates are low, the calculation produces a much higher lump sum value. Current low interest rates make the lump sum option more attractive than in was 10 or 20 years ago.
Of equal importance are the qualitative factors that will impact your final decision; such as:
- Personal health – If you have a shortened life expectancy – given personal health issues or family history of poor health you may want to consider taking the lump sum. Your beneficiary will inherit the full value of your pension.
- Health of pension plan – In addition to your own health, you also need to check the financial health of your company’s pension plan. Your pension is likely to get affected if your company or its pension is in trouble. If there is a risk to your pension payments in the future, it may be wise to take the lump sum payment.
- Cash flow flexibility – Taking a lump sum payment gives you the flexibility to make large withdrawals in case of emergency where a pension plan does not.
- Market risk – When you transfer your funds into a locked-in plan or registered plan in most cases you will invest the funds in the market in order to achieve a payment equal to your pension payment. In doing so your payment will fluctuate based on the current value of your plan calculated on December 31 of the previous year.
- Indexing to inflation – It is important to know if your pension payments are indexed – meaning they increase with inflation year over year – keeping pace with the cost of living. If they don’t that is a good reason to take the lump sum payment.
- Other benefits – If you decide to take a lump sum payment ensure that there is not a loss of other health benefit coverage–medical/dental that would be offered by staying with the pension plan.
The decision to take the lump sum value of your pension or the monthly payments can impact your financial security for the rest of your life. It is important to take the time to consider all the important variables, such as rates of return, life expectancy and personal estate planning issues.