MoneySense Magazine, April/May 2012
Income that lasts a lifetime
Your pension could be your most valuable asset. Here’s how to make the most of it.
This article was first published in the April/May 2012 issue of MoneySense.
If you’re lucky enough to have a pension plan at work, be thankful— it may be one of your greatest financial assets. Yet many employees have only a dim understanding of how their pension plan works and what level of income it will provide in retirement.
Employer-sponsored pensions come in two flavours. Defined benefit (DB) plans promise to provide you with a predetermined amount of money in retirement. If there’s a shortfall, it’s the employer’s responsibility to make up the difference. With defined contribution (DC) plans, your income in retirement is not known in advance: it will depend on the performance of your investments. We’ll help you understand both types.
Along your journey toward retirement, you’ll face some daunting decisions about how to manage your plan. We’ll help you answer all of the most important questions so you can get the most out of your pension. It’s worth the effort: with proper planning, your pension can become the cornerstone of your retirement plan, providing you with steady income that will last a lifetime.
Should I join the plan?
If your boss asked you tomorrow if you’d like a raise of several thousand dollars, would you say no? Of course not. Yet that’s what people are effectively doing when they decide not to join their company pension plan. “These plans have an employer contribution that you won’t get unless you sign up,” says Malcolm Hamilton, a pension expert with Mercer. Signing up for a defined benefit or defined contribution plan is a no-brainer, and if you didn’t do it when you started with the company, ask your human resources department if you can join now.
With DB plans, private sector employees typically contribute up to 5% of their salary, while public sector workers may put in as much as 10%. This money is deducted automatically from your paycheque, so you’re always saving without having to think about it. Your employer also puts money into the plan, and they’re on the hook to provide you with a fixed income in retirement, based on your salary and years of service.
With DC plans, the employer puts in money every year, usually matching a percentage of your earnings. A typical plan might allow you to contribute 3% or 5% of your salary, which would then be matched by the employer. As a result, you double your money once you’re vested.
Another advantage of DC plans is that they help you take advantage of dollar-cost averaging. By contributing a fixed dollar amount to your funds every week or month, you’re buying more shares when prices are low and fewer when they’re high. “It’s worked to our benefit because we’re literally purchasing every month,” says Wendy Harrison Bannister, a professional stock trader in East Gwillimbury, Ont., who manages her husband’s defined-contribution pension investments.
If you feel too squeezed for cash to contribute, it helps to know that the money you put into the plan is tax-deductible, just like an RRSP contribution. Both your contribution and your employer’s contribution will reduce your RRSP room, but you won’t need to wait for a tax refund like you do with an RRSP. “If you’re putting in $100 a month, it’s not going to cost you $100 off your paycheque,” explains Hamilton. “It will only cost you $60 or $70 because it will reduce your withholding tax.”
How should I invest the money?
One of the great things about DB pension plans is you don’t need to make decisions about how to invest: that job is handled by a professional money manager.
With a defined contribution plan, however, you’ll have to make the investing decisions yourself. Your company works with an investment firm that gives you a choice of funds and provides you with a questionnaire to help assess your risk tolerance. The rule of thumb is you should invest more of your money in equity mutual funds when you’re young and can afford to wait out a market crash, and shift towards lower-risk investments, such as bond funds and GICs, when you’re closer to retirement. By your mid-50s you should have around half of your money in low-risk investments. However, don’t be too conservative—if you put all your money in bonds or GICs, your portfolio will likely lose purchasing power due to inflation.
Make sure you choose low-fee mutual funds if they’re available. In general, investors should look for equity funds with MERs (management expense ratios) of 1.5% or less, and bond funds with MERs of 1% or less. Fortunately, many pension plans offer funds with fees lower than those available to the general public. “The mutual fund we invest in has a fee that is 0.25% higher if you buy it outside the pension plan,” says Wendy Harrison Bannister. “This has a big effect on your returns over time.”
Is my pension safe?
In recent years the media has buzzed about the apparent pension crisis. Should you be worried that after decades of paying into your defined benefit plan it won’t have any money left when you retire?
“The bad news is most pensions today are not well funded, because we’re coming off of a string of years when investments did surprisingly badly,” says Hamilton. “The good news is it doesn’t make any difference whether the plan is badly funded or not, as long as the employer sponsoring the plan is financially healthy. If you work for a bank and you have an underfunded pension plan, it’s the bank’s problem, not yours. If you work for the government, it’s the government’s problem.”
Pension money is held in trust, so the employer can’t raid your retirement savings to pay other bills. As long as the employer is operating, it is legally obligated to make up for any shortfalls needed to pay retirees. However, if your company goes bankrupt while the plan is underfunded—a situation that Nortel workers faced—you might get less than expected. “Even in those cases, it doesn’t mean that people get zero,” says Brian FitzGerald, an actuary at Capital G Consulting and author of The Pension Puzzle. “They get 80% to 90% of what they were promised, so it isn’t as disastrous as people think.”
Pension plan members also face the risk of having their employer close the plan while they are still working. “A sponsor has a choice to continue to offer a pension plan or not, so there is always a possibility of changes,” says Martine Sohier, account director and actuary with human resources consultant Towers Watson. Many employers are opting to close down expensive defined benefit plans and are offering defined contribution plans instead. If that happens, you’ll be credited with the amount you’ve earned so far.
Members of DC plans are less dependent on their employer’s situation, as their investments are held in separate accounts earmarked for each employee. The amount you’re owed is clear—it’s simply the current value of the investments in your account. The main risk for these employees is that a market crash could wipe out a big chunk of their savings.
Should I save outside the plan?
If you are a member of a pension plan, do you also need to save in RRSPs? That depends on what type of plan you have, says Hamilton. “If you’re a government worker in a plan that says you can work for 30 years and then retire for 30 years and the state will give you better standard of living than you had when you were working, there’s very little reason to save more.”
However, private-sector plans aren’t as generous, so those employees should supplement their pensions with additional savings. Remember that your pension contributions reduce your RRSP room, so take care not to exceed your limit. (You can find your RRSP contribution limit on the Notice of Assessment you receive from the Canada Revenue Agency at tax time.)
Wendy Harrison Bannister makes sure she looks at her family’s DC pension and non-pension investments as a whole, so she can avoid the risk of having too much in one sector or asset class. “I try not to double dip,” she says. “We have a mutual fund that focuses on Canadian banks in our pension plan, so I never buy Canadian bank stocks in our other accounts.”
What happens if I leave the company?
If you leave your job before passing your company’s vesting period, you’ll simply get your own contributions back, plus interest. You can transfer that money to your RRSP or take it in cash, in which case it will be subject to income tax.
If your pension has vested, then you will have some choices to make. DB plan members can leave their credits in the current plan, and when they reach retirement age they’ll collect monthly income. This is the best option for most people, as it offers professional money management as well as guaranteed income for life.
If you’re under 55 when you leave your company, you’ll be offered the option of taking your pension benefit as a lump-sum payment. If you take the lump sum, it will go into a Locked-in RRSP or Locked-in Retirement Account (LIRA), depending on your province. These accounts are tax-sheltered, but you can’t withdraw the money before a specified age.
In theory, it makes no difference if DB plan members take a lump sum or leave it in the plan—the lump sum is calculated to have the same value as the future income stream of the pension. Taking a lump sum makes sense if you’re financially savvy enough to invest more successfully than the pension plan managers, but few people are in this camp. It’s also a good idea if you fear your company might go bankrupt. However, you need to make sure that if you leave the plan you aren’t inadvertently giving up any health benefits or early retirement incentives. Also, be wary of financial planners who advise you to take your pension as a lump sum: sometimes they’re swayed by the idea of receiving hefty commissions for reinvesting your savings.
DC plan members may also have the option to keep their funds invested in the plan when they leave the company. If they take the lump sum, it will be put into a locked-in retirement account.
Just to make things more complicated, you may have the opportunity to bring your pension credits to your new employer’s pension plan. “Some people want to do this if they’ve had six jobs and six different pension plans,” says FitzGerald. “It’s more convenient to have it all in one place.” You may also be offered the choice of buying an annuity, a product sold by life insurance companies that provides guaranteed income for life in exchange for a lump sum.
If you’re not sure which option is best for you, talk it over with your financial planner or pay for a consultation with a fee-for-service actuary. A list of actuaries who take new clients is available at www.actuaries.ca.
How much will I get in retirement?
If you have a DB plan, read your pension booklet to see the formula for how your benefits are calculated. A “final average” plan bases your retirement income on the last few years of your career. For example, it might provide 1% of your average income in your last three working years, multiplied by your years of service with the company. Other plans base the calculations on your career average earnings, or pay a flat dollar amount for each year of service. The best plans—typically those for government workers—provide income that is indexed, meaning your monthly payments will gradually increase in retirement to partially or fully offset inflation. Every year, your employer will send you an estimate of your projected pension income in retirement.
If you have a DC plan, it’s harder to predict what you’ll end up with at retirement. Use a retirement calculator such as the RRSP savings tool at getsmarteraboutmoney.ca to figure out how much you are likely to save and how much annual income it would provide. Remember to include your employer contributions in your calculations.
What happens if I retire early?
Megan Barker, a 53-year-old nurse and single mom in Peterborough, Ont., is keen to retire at 55. “I’ve been an operating room nurse for 28 years and it’s heavy work some days,” says Barker (we’ve changed her name to protect her privacy). But she’s not sure if her pension and other investments will be enough to live on.
People with DB plans who are considering early retirement should read their pension booklet to find out how much their monthly income will be reduced as a result. You could lose 6% or more for each year you retire early. “If you retire five years early, you could reduce your pension by 35% to 40%,” says FitzGerald. “It’s quite severe, because the benefit is going to be paid to you for an extra five years.” You may be eligible for bridging benefits, which will top up your income in the time period before you’re eligible for full Canada Pension Plan and Old Age Security at age 65. If not, you may need to dip into your RRSPs to bridge the gap.
If you have a DC plan, retiring early is even harder. “Not only do you need to live off your money for an extra 10 years, but you also need to save much more,” says Hamilton. “If you do the projections you may find out that you need twice as much money to retire at 55 rather than 65.”
In Megan Barker’s case, she’ll get $3,250 a month from her pension if she retires at age 55, instead of $4,330 at age 65. However, she’ll also get a bridging benefit of $580 a month until age 65, plus she has around $400,000 in her RRSP and non-registered accounts. FitzGerald says that since her mortgage is paid off and she’ll get around $15,000 a year in government benefits at age 65, she will be able to retire at 55 without experiencing a significant drop in lifestyle. “I think she’s in pretty good shape,” he says.
What decisions do I need to make when I retire?
Judy and Peter Walsh of Nanaimo, B.C. are overwhelmed by the decisions they need to make as they approach retirement. “It’s making our heads spin,” says Judy (the couple’s names have been changed to protect their privacy). Both are government workers and they are struggling to decide if they should take a reduction in Peter’s pension in order to provide survivor benefits for Judy. Another option is to take a reduced monthly sum in order to get a guaranteed number of payments, regardless of when Peter dies.
Pension law requires that you and your spouse are offered a joint-and-survivor pension that makes payouts until both partners die, but you can opt out if your spouse agrees. FitzGerald says Judy and Peter are probably better off taking the higher monthly pension instead of any spousal benefits or guarantees. Judy will experience a drop in household income if Peter passes away first, but she will likely have enough money from her own pension to cover her needs. “If they are in roughly the same salary range and they both have good pensions, they have no need for the joint pension.”
However, if your spouse would suffer a huge drop in living standards with the loss of your pension, you’re better off choosing an option that provides payouts to your spouse after your death. You might also opt for a survivor pension or guarantee if the pension member is in poor health.
Some plans give you the option of converting some of your pension money into an annuity. If you have a DB plan, it’s probably not necessary, unless you think your company is likely to go bankrupt. If you’re in a defined contribution plan, you might want to consider buying an annuity as a way of ensuring regular income. However, check annuity prices at several insurers before you purchase anything.
If you need help making these decisions, don’t be afraid to hire a professional. An hour-long consultation with an actuary may be all you need to feel confident about your pension and retirement choices, and it could set you back as little as a few hundred dollars. For a few thousand dollars, you can find a fee-only planner who will do a complete financial plan that will start you off on the right path for the next phase of your life.
MoneySense Magazine, April/May 2012