Commuted value or monthly pension: how to weigh a lump sum against a lifetime income

What a commuted value is

A defined benefit pension promises an income based on a formula, often years of service multiplied by a percentage of earnings. When you leave before retirement, that promise usually becomes a deferred pension payable from the plan's normal retirement age.

The commuted value is the plan's estimate of what that future stream is worth today. It is calculated by the plan's actuary using prescribed methods that rely on interest rates and life expectancy assumptions at the time of the calculation. Because those inputs move, the same pension can produce a noticeably different lump sum depending on when it is calculated.

If you're not sure which type of plan you have, our guide to defined benefit vs defined contribution pensions explains the difference.

Where the money goes if you take it

Pension rules generally require the commuted value to move into a locked-in account, such as a locked-in retirement account, rather than being paid to you as cash. Locked-in money can later fund a life income fund or an annuity, with limits on how much can come out each year that vary by jurisdiction.

Tax rules also cap how much of a commuted value can move to a registered account without tax. Any portion above that limit is typically paid to you as taxable cash in the year you receive it, which can create a large one-year tax bill. The exact limit depends on your age and pension, so it's worth asking the plan administrator for a written breakdown and confirming the treatment with the CRA.

What you give up and what you gain

Each path carries a different mix of risks. Seeing them side by side can be more useful than comparing two dollar figures.

• Keeping the pension: income for life no matter how long you live, no investment decisions, and often a survivor pension for a spouse. The trade-off is less flexibility, exposure to the plan's own funding health and, for many plans, little or no inflation protection.
• Taking the commuted value: control over investments and timing, the possibility of leaving remaining money to heirs, and portability if you move. The trade-off is that you carry investment risk, inflation risk and the risk of living longer than the money lasts.
• Things beyond the pension itself: some employers link retiree health or dental benefits to receiving a pension, and early-retirement subsidies may be built into the pension but not fully reflected in the lump sum. Plan documents and your termination statement describe these.

A worked example: Daniel's two paths

Suppose Daniel is 55, lives in Ontario and is leaving his employer for another job. His plan offers either a deferred pension of $24,000 a year starting at 65, not indexed to inflation, or a hypothetical commuted value of $380,000. These are made-up figures for illustration, not a market quote.

Daniel also has $150,000 in his RRSP and $50,000 in his TFSA, and he plans to add $8,000 to his RRSP and $7,000 to his TFSA each year until he retires at 65. His CPP estimate at 65 is $1,150 a month, and he wants $55,000 a year after tax. The calculator assumes 6% returns before retirement and 5% after, with 2% inflation, and works in today's dollars.

If he keeps the pension, his own savings reach about $480,299 by 65. Because the pension isn't indexed, its value in today's dollars slips to about $21,738 at 70, $17,832 at 80 and $14,629 at 90. The plan still reaches 95, with about $113,331 left after tax.

The lump-sum path in the same model

If Daniel instead moves the hypothetical $380,000 into a locked-in account, the calculator treats it as part of his registered savings. With the same return assumptions, his total savings reach about $1,038,564 by 65, and about $433,906 remains after tax at 95.

Another way to compare is the steady after-tax spending each version supports to 95. With the pension, that's about $57,200 a year; with the commuted value, about $63,100. If the pension were fully indexed to inflation, the pension path would support about $60,900.

How sensitive the answer is

The lump sum's advantage in Daniel's example comes almost entirely from the assumed returns. When the calculator lowers them to 4% before retirement and 3.5% after, the pension path supports about $51,400 a year and the commuted value path about $51,500, essentially a tie.

The size of the lump sum matters just as much. If the commuted value were $300,000 rather than $380,000, at the original returns it would support about $58,900 a year, much closer to the pension's $57,200.

The model also can't capture everything. It assumes Daniel lives to 95; a pension keeps paying beyond that, while a lump sum invested poorly or drawn too quickly may not. On the other hand, if he died early without a survivor benefit, remaining commuted-value money could pass to his estate. A fixed set of assumptions can't tell you which of those outcomes will happen.

Questions worth asking before you decide

Commuted value elections normally have a deadline, so it helps to gather information early. The retirement plan tool lets you enter both versions of your own situation, and the how much do I need calculator shows whether either path covers your spending target.

• Is the pension indexed, partly indexed or flat, and is there an early-retirement subsidy?
• What survivor benefit would a spouse receive under each option?
• How much of the commuted value can move tax-free, and how much would be paid as taxable cash?
• Are any retiree benefits tied to keeping the pension?
• What does the plan's most recent funding information show, and how comfortable are you managing investments for 30 years or more?

Fitting the choice into your wider plan

The commuted value decision interacts with everything else: when you start CPP, how you sequence withdrawals, and how much lifetime income you want as a floor. Some people who take a lump sum later convert part of it into an annuity to rebuild a lifetime income; our annuities in Canada guide explains how that works.

Because the choice is usually irreversible and depends on plan-specific rules, many people review the plan's documents, the termination statement and the applicable pension legislation before signing, and confirm the tax treatment with the CRA.