Pensions: Raking it in

Your pension may be your largest financial asset. But few of us understand how pensions work. Here’s a 10-minute guide to what you must know.

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by

From the June 2009 issue of the magazine.

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If you’re under 45, chances are that you never read the annual statement from your employer pension plan. Once you get past 45, though, the document grows more interesting with each passing year. By the time you’re closing in on retirement, your pension statement becomes absolutely fascinating. But what to make of it? Is your pension a good deal? Should you be worried about your employer’s finances? Let’s look at three common questions about pensions.

Is my employer pension enough to retire on?

Unless you’re a long-time government employee, probably not. Most private sector pensions are intended to help with retirement, but not to finance the whole shebang by themselves.

As a rough guide, you should assume that you will need a retirement income of 50% to 60% of your working income to enjoy the same standard of living as you did while working. Government stipends, such as Canada Pension Plan (CPP) and Old Age Security (OAS), give you a big head start on getting up to that 50% level. A husband and wife who have worked in Canada all their adult lives and who retire at 65 will collect, between them, an average of $22,000 a year from CPP and OAS.

Most of us will want to supplement those government payouts with other sources of money. That’s where pensions come in. Your first step in assessing your pension should be to figure out which type of pension you have.

Many private sector pensions are “defined contribution” plans. In these plans, your employer contributes a set amount on your behalf each year. The employer’s contribution is typically 4% to 5% of your salary, says Brian FitzGerald, an actuary with Capital G Consulting and co-author of The Pension Puzzle. It’s up to you to decide how to invest the money, usually by choosing from among a menu of mutual fund-like options. If you make good decisions, these plans can work out well. But if you make bad decisions, tough luck.

A more stress-free arrangement is what is known as a “defined benefit” plan. This is what most people mean by a company pension, although the classic version of such pension plans is becoming rarer and rarer outside the public sector. If you have a defined benefit plan, your employer contributes on your behalf. (You may also have to make contributions.) Your employer decides how to invest the money. Finally, the pension plan guarantees to pay you a set amount in retirement. You have no decisions to make.

A typical defined benefit plan at a private-sector company pays you about 1.5% a year of your final salary for each year that you have worked for the company, says FitzGerald. Say you’re 65, you’ve worked 20 years for a company, and you’re earning $100,000 a year toward the end of your career. A typical private sector defined benefit pension would pay you 20 times 1.5%, or 30%, of your final salary. In other words, $30,000 a year.

There’s nothing wrong with that, but defined benefit plans in the private sector typically provide limited protection from inflation, says the actuary FitzGerald. The purchasing power of your pension will decline gradually over the years. Also, private sector defined benefit pensions tend to work poorly if you switch jobs a lot—and in these days of a mobile workforce, who doesn’t? That’s because when you leave a private sector employer, the salary used in the computation of your eventual pension is typically frozen based on what you earned at the time. There is no adjustment for subsequent inflation. The job you left in 1989 will pay you a pension based on a percentage of your salary from the late 1980s.

Public-sector employees usually enjoy a much sweeter deal. Defined benefit pension plans for teachers and government workers typically pay 2% per year of service if you retire at 65, and offer either full or partial protection from inflation, says FitzGerald. Thus, if you worked in a government job for 35 years before retiring at 65, your employer pension plus CPP will likely provide you with an impressive 70% of your pre-retirement income. And your pension will rise in line with inflation.

The bottom line is that long-term public-sector employees shouldn’t fret about saving large amounts for retirement. So long as they keep working until 65, and have at least 25 years on the job, their pensions will probably provide at least half their working income in retirement. They may want to supplement that with their own money, but their pension provides an unbeatable foundation.

Private-sector employees, though, will probably have to build up their own RRSPs if they want to enjoy a good retirement. They will also have to face more risk. Which brings us to our next point.

My employer’s defined benefit plan is underfunded. Should I be worried?

What happens if my employer goes bust? You should keep track of the status of your employer’s plan, but you probably have less toworry about than you think.

Many defined benefit plans have recently accumulated large shortfalls, says FitzGerald, the actuary. Shortfalls occur when the assets of the plan aren’t big enough to cover the projected cost of future payouts. As a result of the market crash and other factors, many plans are now underfunded by 15% or more.

This is not an ideal situation, but the shortfalls may not affect you at all. If your plan is 100% funded by your employer, and your employer stays solvent, then the shortfall is your employer’s problem, not yours. If markets stay down, your employer must make up the shortfall over time.

On the other hand, some pension plans divide the responsibility for a shortfall between employer and employees. If this is the case where you work, then both employees and employer will have to kick in more cash to make up the difference if markets don’t recover.

The law gives priority to protecting pensions that have already been earned, so if you’re already retired, a shortfall likely won’t affect you. Instead the employee share of any shortfalls will fall largely on working employees. They will have to contribute more money or agree to reducing the benefits they can expect.

The worst case comes if your pension plan has a shortfall and your employer goes out of business. If that happens, your pension might end up being reduced—but only by the extent of the shortfall. In other words, you might lose something, but you won’t lose everything, says FitzGerald. Pension assets are held in trust, so a failing company can’t grab them to pay other bills when it’s trying to stave off bankruptcy.

Provincial governments try to protect pensions where possible. Ontario, for instance, has a Pension Benefits Guarantee Fund that’s intended to cover pension underfunding up to certain limits if a company goes bust. However, there’s not enough money in the fund to cover potential shortfalls from automakers and other companies now teetering on the edge of bankruptcy. If some of these companies go under, it’s not clear if the Ontario government will help bankroll a pension bailout.

I’m changing jobs. Should I take my money out of my former employer’s pension plan?

Your options depend upon what type of pension you have.

If you have a defined contribution pension or a similar arrangement known as a group RRSP, there shouldn’t be any problem taking your money out if you’re unsatisfied with the invesment choices in your former employer’s plan.

If your former employer has provided you with a group RRSP (which technically isn’t regarded as a pension plan), then you’re subject to regular RRSP rules. You can transfer your money to another RRSP with no tax implications, but the money is taxable if you cash it out.

If your plan is a defined contribution plan, you generally face restrictions on what you can do with the money. You will probably have to keep it in specific investments that ensure you an income in retirement. The most common is the “locked-in” equivalent of an RRSP. This is known as a Locked-In Retirement Account or LIRA. The rules for locked-in investments vary by province and generally limit your ability to tap into your cash before retirement age.

If you have a defined benefit plan, you may discover that you can only get your money out through the eventual pension payments themselves. However, if you leave the job before you reach early retirement age — often 55 — many plans allow you to take out the lump sum equivalent value of your pension. Again, though, you probably can’t just take the cash and run. You are generally limited to moving your money to investments, such as LIRAs, that ensure income in retirement.

In such cases, your best bet is likely to leave the money in your former employer’s pension plan. It’s hard to beat the defined benefit pension’s assurance of guaranteed income for life, says FitzGerald.

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