The pros and cons of offering pension portability at retirement

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The two key reasons a plan sponsor may choose to offer portability options to members who are eligible to start their pension are de-risking and member choice.

• De-risking:

Offering portability to all eligible members is one way for a plan sponsor to reduce pension risk. The transfer of a lump-sum value of a pension from the plan settles the associated obligations. It also transfers the related risks — such as investment, interest rate and longevity — to the former member. For a plan sponsor whose ultimate goal is to settle all of its pension obligations, offering portability to all terminating members, regardless of age, moves the sponsor further along the path towards that goal.

• Member choice:

Offering portability provides additional choice and flexibility, which plan members may appreciate. For some members, the option of controlling the investment and management of the lump-sum value of their account during retirement is appealing, especially if they have concerns about the future stability of their employer and the financial strength of the plan. Also, pension legislation in some Canadian jurisdictions permits plan members aged 55 or older to unlock up to 50 per cent of their funds, thereby facilitating a wide range of savings and estate-planning strategies.

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For plan sponsors considering broadening the portability rights under their plan, there are a number of important considerations:

• Additional risks for former members:

The risks related to investments, interest rates and longevity don’t disappear; rather, they shift to the former members and their spouses. For example, if the investments made with the lump-sum value underperform or the retiree lives longer than expected, the lump-sum value may prove insufficient to provide retirement income for the lifetime of the former member and his or her spouse. The potential erosion of retirement income through retail investment management fees is another consideration, as is the individual’s ability to manage the investment in the latter stages of life.

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It’s important to note, however, that many private sector employers have closed their defined benefit pensions in the last two decades and have established defined contribution plans for newly hired employees. Employees in a defined contribution plan are already managing the risks associated with their pension accruals throughout their lifetimes, so employers may not worry too much about a former defined benefit member electing portability and thereby assuming the same risks.

• Tax treatment of lump-sum transfers

If a plan member elects portability, pension legislation requires the transfer of the lump-sum value on a tax-deferred basis to a registered locked-in retirement savings vehicle (such as a life income fund), except when the payment is relatively small or qualifies for special unlocking. However, the Income Tax Act limits the amount that can be transferred from a defined benefit plan on a tax-deferred basis.

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In the current environment of low interest rates, a significant portion of an older member’s lump-sum value will likely exceed the Income Tax Act limit. The loss of the tax shelter on a substantial portion of the pension value can erode the level of retirement income. This immediate unlocking and taxation may also encourage the member to spend that portion, rather than treating it as retirement savings.

• Potential cost increases:

Pension legislation requires that the interest rates used to calculate lump-sum commuted values are based on bond yields. That means the cost of settling a member’s pension through a lump-sum transfer is often larger than the expected cost of providing the person with a monthly pension payable from the plan. That rise in expected cost may, over time, increase the plan’s funding requirements.

• Anti-selection:

Obviously, a monthly lifetime pension provides more value to a retiree who lives to an old age than someone who dies shortly after starting a pension. Therefore, when provided with a choice, a member who’s in good health is more likely to elect for a lifetime pension payable from the plan, while someone in poor health is more likely to elect a lump-sum transfer. If that type of anti-selection becomes prevalent, providing the option of portability may increase plan costs.

• Communication:

The administrator of a plan offering portability to a retirement-eligible member should consider how best to communicate that option. What information and resources are available to help members make an informed choice? Does the information reflect all minimum compliance requirements? For example, the election form should clearly disclose the portion of the lump-sum value that will be transferred on a tax-deferred and locked-in basis and any portion paid in cash.

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Also, pension legislation in some jurisdictions, such as at the federal level, requires written spousal consent, given the spouse faces the potential loss or diminishment of a survivor pension. Finally, the materials should instruct members to seek advice from an independent and qualified advisor who considers their personal situation and is transparent about investment risks and fees.

Although there are a number of considerations associated with offering portability to retirement-eligible members, there are also some long-term benefits to the employer. A plan sponsor that would like to reduce its pension-related financial risks and increase member choice and flexibility should take a closer look at the merits of providing that option.