Changing Employment? Pension Options Explained.

By David Lush, CFP

Accepting a severance package or forced retirement from work is a significant milestone. With the world an even more uncertain place in 2020, there is a lot to learn, and learn quickly. You’ve worked hard for decades just to put you and your family in a secure financial position. So why wait until just before you retire for quality retirement advice? For your benefit and your family’s, the best option is to start planning now. Receive all the retirement advice that you can sooner rather than later, and research your pension options. This guide will help you if you are in an uncertain future, and unsure what to do with your earned amounts from your employer, and what to do when presented with an option of a lump sum payment from your employer, or to keep the pension. 

While pension options are not as complex as they sound, it is always best to be prepared. Every person’s individual and family situation is different. By learning about your pension options ranging from pension transfers to pension early retirement, you will know how to best protect yourself and your family.

What is a pension?

Before going into any type of detailed research on what pension option to choose, the first thing to do is answer the question “what is a pension?” A pension refers to any plan, fund, or scheme, usually through an employer, which provides retirement income. Pension funds require an employer to make contributions to a pool of funds set aside for a worker’s future benefit. This pool of funds, which is then invested on an employee’s behalf, generates income for the worker upon retirement through the fund’s returns and earnings. Pension funds typically have large amounts of investable capital and are some of the largest investors in both public and private companies. Why is this so important to know? The benefits earned from a pension plan may be the largest source of income one will receive upon retirement. 

How does pension differ from an RRSP?

A Registered Retirement Savings Plan (RRSP) is a retirement saving and investing vehicle for both employees and self-employed workers in Canada. The way that RRSPs work is pre-tax money is deposited into an RRSP account, and grows tax-free until withdrawal. Once funds are withdrawn, they are taxed at the marginal rate. Think of this as a savings vehicle with massive tax deferral, with the intention of funding your retirement cash flow needs by providing you with future income.

While both RRSPs and pension plans are retirement plans registered with the Canada Revenue Agency, there are significant differences between the two. While RRSPs are individual retirement plans, pension plans are plans established by companies to provide pensions to employees. Pension plans can be more efficient in delivering retirement incomes than any individual RRSP option, as the RRSP requires that the individual saves, whereas pensions are normally forced savings by the employer and/or the employee. 

Pension plans are generally more cost-effective, efficient, and most importantly, less risky for the individual. Because RRSPs are individual accounts, the investment risk falls largely on the shoulders of the holder. However, with pension plans, much of the risk falls on the shoulders of the employer. While there are certain pension plans where the risk falls at least partially on the employee as well, there is still significantly more protection. 

Pension plans can be split into two major categories, Defined Contribution (DC) plans and Defined Benefit (DB) plans. Pensions are increasingly adopting the DC plan model. DC plans allow employees and employers (if they choose) to contribute and invest funds to save for retirement, while DB plans provide a specified payment amount in retirement. Although pension plans are traditionally DB plans, these types of plans are now considered to be a dying breed. Employers simply do not want to take on the investment risk, and the accounting is costly. 

What are the Main Financial Issues to Consider When Leaving an Employer or Taking Severance?

There are several financial issues to consider before leaving an employer or taking severance. The first two, which were already briefly discussed, are retirement allowance planning and pension plan options. The other two things to consider are salary continuance, company benefits, and health insurance.

What are Four Pension Options when Leaving an Employer?

When leaving an employer, there are four main pension options to be mindful of. Remaining in the pension plan, purchasing an annuity, transferring your pension value to a LRSP/LIRA, and transferring your pension to a new employer. Each of these pension options has significant pros and cons to be mindful of. 

Remain in the Pension Plan

When leaving a company, an option likely exists to stay in the company’s pension plan. While an employee can no longer make contributions to the pension plan after leaving the company, remaining in the plan may provide benefits and incentives such as indexing to inflation or continued access to group health, dental and insurance plans. Often, severance packages also offer pension inducements, such as added years of service. This, of course, depends upon age and position. These types of benefits can make remaining in the pension plan enticing. But before doing so, be sure to understand all of the pros and cons.  

There are several pros to consider before deciding to remain in a pension plan. First and foremost, remaining in a pension plan offers significant security. The plan’s benefits are payable for the life of an annuitant, and if the plan member dies before the start of pension payments, the commuted value may be available to a surviving spouse or beneficiaries. While DC plans are becoming more commonplace than DB plans, if the pension is a DB plan, the fund administrator makes all of the investment decisions, and takes on all of the risk. As mentioned before, remaining in the plan also indexes for inflation. This is highly beneficial to an investor who is shy on investing their personal funds into higher risk assets like equities, as it offers another significant security blanket. 

There are, however, several cons to consider. While remaining in a pension plan is a solid option for safety and security, it does not offer significant flexibility or freedom. Once an employee is no longer with a company, yet still in that company’s pension plan, they have limited to zero ability to access lump sums from the pension plan. Additionally, modifying pension payments once they begin is nearly impossible. Furthermore, although the commuted value may be available to a surviving spouse or beneficiaries if the plan member dies, if pension payments have started, the spouse generally receives a reduced monthly payment for the remainder of their lifetime. Lastly, if the pension plan is a DC plan, the plan member is responsible for investment decisions, subject to limited choices, and takes on all the risk instead of the fund administrator.

Luckily, if you are an astute investor, there are several options for you to financially plan for different outcomes, and even use some tricks in the tax code to hedge your risks. More about this in our final section of this piece.

Purchase an Annuity

Purchasing an annuity is another popular pension transfer option. When leaving a place of employment, it is possible to request that the pension plan administrator transfer the value of a pension to an insurance company to buy an immediate or deferred annuity. The annuity pays a set amount of income starting at the age set out in the annuity contract. 

There are several pros to purchasing an annuity. Purchasing an annuity adds significant security with consistent income streams. Once the annuity is chosen, details and rates are guaranteed, agreed to, and locked in. There are also various available options with annuities to protect a surviving spouse and/or estate. The insurance company also assumes all risks associated with investment performances, with zero risk falling on the shoulders of the plan member. But the most important benefit from purchasing an annuity? It’s guaranteed income for life. 

There are still several cons to be concerned about before purchasing an annuity, however. Annuities do not offer flexibility. There is little to no liquidity with annuities, it is difficult to withdraw funds or access lump sums from the annuity contract, and it is difficult to modify payments once they begin. Annuities can also be taxed higher than other pension options and charge higher fees such as upfront sales charges that are higher when compared to mutual funds, for example. Many annuities also come with a surrender fee, which one incurs if they withdraw funds within the first few years of the contract. Surrender periods can last between six to eight years, but usually are longer.

Transfer Your Pension Value to a Retirement Vehicle, such as RRSP/LRSP/LIRA

There is a third pension option which many individuals choose. This option consists of transferring the value of a pension to a Registered Retirement Savings Plan (RRSP), a locked-in RRSP (LRSP), or a locked-in retirement account (LIRA), depending on how the pension itself is set up. This option allows an individual to invest the money themselves and have sole discretion on choosing when to begin withdrawing funds. Of course, this is subject to age restrictions and annual minimum and maximum amounts.  

For individuals looking for more flexibility and autonomy over their retirement income, this option has significant pros. This pension option offers the most flexibility regarding the amount of annual income that may be withdrawn. There is also more flexibility with delaying the receipt of income and permitting the retirement vehicle to potentially grow in value. There is also more flexibility to withdraw lump sums and/or unlock funds from the LRSP/LIRA for increased availability at a later date. 

Compared to other pension options, this option also offers the plan member the most discretion when deciding the degree of involvement they want with investments and investment solutions. If the plan member dies, this option also offers attractive security for the surviving spouse and estate. The surviving spouse may receive 100% of the remaining plan value on a tax-sheltered basis, and also may have increased access to lump sums. If there is no surviving spouse, the remaining plan value may be payable to the estate or other beneficiaries. 

While the pros are certainly appealing, there are cons to be concerned about as well. With more autonomy and control over the pension, comes more risk and responsibilities. First and foremost, the plan member with this option assumes the most investment risk. Because this plan offers the most flexibility and control, it also offers the least amount of investment risk protection. Additionally, in the event of a plan members death without a surviving spouse, the estate assumes sole responsibility for paying taxes.

Of course, you can also have these funds professionally managed which can help mitigate some risk with proper investing strategies. 

Transfer Your Pension to a New Employer

If retirement is not on the horizon, and one is simply switching jobs, it may be possible to transfer the vested amount of the current pension into a new employer’s pension plan. But doing this involves several ifs, ands, or buts. Several of the pros and cons for this pension option depend on the situation and structure of the pension transfer.  

If you terminate employment with your new employer, and remain in that employer’s pension plan, the pros and cons for the first option – remaining in the pension plan – largely apply. For a plan member, there is significant security, lifetime benefits, protection for spouses and beneficiaries, lack of investment risk if a DB plan, and indexing for inflation if shy on equities. But keep in mind, that there is also no significant flexibility or freedom. There is limited ability to access lump sums or modify payments once they begin, a surviving spouse will receive a reduced monthly payment for the remainder of their lifetime if payments have started, and the plan member assumes investment risks without the autonomy to make decisions if a DC plan.

If you terminate membership in your new employer’s plan and purchase an annuity or move to a LIRA or locked-in RRSP instead, the pros and cons are largely the same as the second and third pension options. Annuities add security, zero risks, and guaranteed rates and income streams for life. On the other hand, annuities are illiquid, offer zero flexibility, are taxed higher, and include higher fees, sales charges, and surrender fees. Transferring the lump-sum amount offered to a locked-in RRSP (LRSP) or a locked-in retirement account (LIRA) offers by far the most autonomy, flexibility, and freedom, while also offering the least protection from investment risks.

How Do You Know Which Option Is Best? 

When deciding on the best pension option, the number one goal should be to choose the option that offers the most cash flow throughout your retirement at an acceptable risk level. There are several factors to consider when deciding on the best pension plan is to move forward with. As mentioned before, every pension option offers pros and cons regarding these factors. When choosing the right pension plan, it takes weighing these priorities.

Always consider the importance of flexibility to access regular income and lump sums, benefits available to your spouse and beneficiaries upon death, degree of involvement in investment decisions, investment risk, and access to ancillary benefits that may be contingent on membership in the company pension plan. Depending on how much importance you put on one factor over another will guide you on what your best pension option should be. 

Financial Planning Opportunities

We mentioned before that there are some financial tricks you can use to maximize your options. By making use of financial planning and wealth management, you can potentially use pensions for three principal opportunities: unlocking your pension amounts for flexibility, utilizing a LIF meltdown, and investing in life insurance with the pension lump sum.

Opportunity 1: Unlocking Pension Amounts for Flexibility

If you left a company with a pension before retirement, there is a high probability that you had to move the money into a Locked-in Retirement Account (LIRA). Why? Because neither the federal nor provincial governments generally permit the conversion of a pension into cash. LIRAs are designed for the accumulation of money that originated from a pension plan and do not allow for lump sum withdrawals. 

But are there exceptions to this rule? In short, yes. While the only way to unlock your pension account is to retire or be a minimum of 55 years old, there are exceptions. Depending on the province you live in, you can transfer your pension to a Life Income Fund (LIF), a Life Annuity, and a Life Retirement Income Fund (LRIF) where acceptable. 

While generally becoming a non-resident of Canada allows you to unlock your pension, provinces have different definitions of the following exceptions: access to small amounts, shortened life expectancy, financial hardship, and 50% Unlocking. Alberta, for example, has 5 categories of financial hardship exceptions, and permits unlocking up to 50% of your holdings and transferring them to an RRSP without any withdrawal restrictions. This is an extremely attractive option to increase your flexibility and enhance your retirement.

Opportunity 2: Utilize LIF Meltdown

Using a LIF meltdown strategy is another opportunity to put your pension to work with a little financial planning. As mentioned before, it is possible to transfer your pension to a LIF depending on the province you live in. This is similar to an RRIF meltdown strategy where you pay the interest accrued on a non-registered investment loan with deregistered funds from a registered plan. In other words, this strategy uses debt expenses to offset taxes, as interest expense incurred while investing is a tax-deductible cost. Many hail this strategy as a tax-free way to withdraw funds from a pension. LIF meltdowns work similarly, with the caveat that LIFs have a minimum and maximum amount that you can withdraw annually. Additionally, while many assume this is a tax-free withdrawal of pension funds, in reality, this concept just offsets the income inclusion of their pension withdrawal with an interest expense deduction. There are leveraging risks to be mindful of as well, and a professional should be consulted prior to going forward with this strategy.

Opportunity 3: Invest in Life Insurance with Pension Lump Sum

The third opportunity is using life insurance as a way to offset lump sum payments you could have taken. If you were to leave the pension in the company, instead of taking a commuted value to an RRSP/LIRA, that commuted value is lost upon death of you and your spouse as the pension will not pay the monthly amounts to the estate. As an option to keep the estate net worth comparable to transferring said commuted value, while maintaining the luxury of full pension payments in retirement, life insurance can be used to cover the cash value of that pension. This may be the best of both worlds. In the second scenario where the pensioner opts to take the commuted value and transferring to an RRSP/LIRA initially, you can also utilize life insurance to offset estate taxes. Your cash value amount, upon you and your spouse’s death, will be fully taxable to the estate. You can offset some or all of these estate taxes with a life insurance payout at the same time and increase the generational wealth transfer. 

While this discussion by no means has covered everything in regard to pensions and major life situations, it will hopefully offer an intro to what your options are if you are facing an uncertain future due to a forced early retirement or are changing careers.

If you are looking for further advice, reach out to us at ClearWater Private Wealth, or email our President David Lush, CFP, directly ([email protected]) and let us guide you through the process. We are here to help and can assist you in maximizing your family’s financial future.