Defined Benefit Pensions: Steps to Get the Most Out of Your Pension
Some people like to say God that is “in the details” while others claim say it is the devil that calls the shots. In any event, the financial planner part of me wonders if whoever coined these expressions was secretly thinking about defined benefit pension plans. Sometimes, the details of a plan are a safety blanket that makes sure you’re covered regardless of what happens next while in other instances, the fine print is a trip wire that leads to catastrophe. Fortunately, whether your plan is a safety net or tsunami isn’t entirely a matter of chance; the choices you make at key points along the way have a lot of impact over what happens later. As a result, I want to talk about some of these key decisions and the things you can do to make your future a little bit more like heaven and a lot less like hell.
Defined Benefit Pensions – The Basics
I am going to assume that most of you that will actually read this article to its bitter end already have a defined benefit pension and know the basics. As a result, I won’t try to reinvent the wheel. Instead, I’ll just add a quick overview to set the stage. Unlike an RRSP or defined contribution plan, a defined benefit plan transfers most of the investment risk to the employer, subject to the exceptions I’ll talk about shortly; instead of telling you what goes in, a “DB” plan promises what will eventually come out, based on factors like:
• how long you’ve worked for that employer or another employer connected to the same pension plan or a former employer if you’re allowed to transfer benefits from your old pension to your new pension plan;
• whether you were working full time or part-time;
• your age when you want to start your pension; and
• some function of your salary, such as an average of your best 5 years earnings, or a promised retirement benefit based on a set dollar amount per hours worked.
Added to the mix, the size of your pension cheques will depend on your particular combination of the above factors and a few more wrinkles like:
• whether you’re allowed a lot of options for how to receive your pension (such as a guaranteed minimum number of payments if you happen to die early into your pension or a full / partial continuation of pension payments for your spouse if you die first) or whether it’s just one stop shopping. If you are allowed different pension options, the size of your pension may go down in order to pay for some of the extra features. As they say, there is no free lunch;
• whether your pension promises full or partial indexing to inflation. Although this may be a surprise to some of you, even pensions that have provided full indexing in the past usually don’t guarantee this going forward. The combination of new contributions, whether members die earlier or later than expected and investment performance determine whether they can afford to increase payments due to inflation in the future; and
• the investment performance of your pension plan and your employer’s financial well-being. For those of you getting a pension funded by the government, this is not really an issue. If the investments inside the pension plan tank, you can be pretty confident that you’ll continue to receive your full pension cheque each month. On the other hand, if you work in the private sector, this is not necessarily the case. I have met many clients who aren’t receiving their promised payments because their employer can’t refill the pension coffers due to investment losses, its own financial problems and because there are a lot fewer working members of the pension plan contributing fresh funds. This can mean drastically smaller pensions that promised and retirees scrambling around to fund a retirement that they had previously thought was financially secure.
In any event, here is the bottom line. When trying to decide the best thing to do with your own particular pension, the key point to remember is that each plan has its own set of rules. In order to use the rules to your advantage and avoid unpleasant surprises down the road, it’s up to you to either master the fine print yourself or find someone you trust who can help. Pensions are a lot like complex board games; if you don’t learn all the rules, the chances of things working out depend a lot more on luck than on skill.
Steps to a Happy Ending
Taking all of this into account, here are some of the things you can do to increase your chances of golfing off into the sunset:
• Learn your deadlines. As some of your decisions must be made by a certain age, don’t wait until it’s too late to read the rule book. For example, in order to commute your pension (i.e. take the current cash value of the promised future benefits and invest them instead), you may have to elect this option by a certain age. If you are worried about your employer and pension’s financial health, it might make a lot of sense to take the money and run. If you wait too late or if too many other people have already done so and your benefits have already been discounted, this may be one of those decisions that will haunt you for years to come;
• Figure out the penalties for retiring early. DB pensions generally have something called a “normal retirement age,” which is the age you can start your pension without receiving less than the promised benefits. While some plans offer this at age 60 (or even 55) or once your combined years of service and age reach a magic number like 85 or 90, other plans make you stick it out to age 63 or 65. Moreover, some pensions will only reduce your benefits by 3% per year for retiring early if you’ve been there long enough, others will charge closer to 8% per year. In order to avoid unpleasant surprises at the last minute or needlessly leaving money on the table, be sure to learn the ins and outs of your own situation and plan accordingly. In some cases, this may mean setting aside a few extra dollars before retirement to tide you through until you can get an unreduced pension rather than starting your pension immediately after you pull the plug and book your first tee-time;
• Determine Whether Your Pension Is A Buffet or a Hotdog Stand. Some pensions give you a lot of choice when deciding how to take your pension while others only offer one option. For example, you may be able to select a minimum payment period or a pension that continues full or partial payments to your spouse for life if you die first. On the other hand, one very large pension only provides 50% benefits to your spouse if you die first, which is supplemented by some life insurance that decreases yearly until it plateaus to a fixed amount of $10,000 when you turn 75. If you are stuck with a pension without choices, this could mean major financial hardship for your spouse if you’re the first to depart this mortal coil, especially since it is pretty common for people to live decades beyond age 75 at this point. If your retirement pension is going to be the family’s most significant financial asset during retirement and you can’t avoid a 50% reduction at your death, it may make a lot of sense for you to get permanent life insurance well prior to retirement to help solve this problem. If you wait too long, you may be either uninsurable or the cost of coverage means that you can’t afford to get as much coverage as you really need;
• Avoid Comparing Apples to Oranges. Most pension plans mail out yearly statements that tell you what you can expect to receive when you retire if you keep chugging along as is until retirement. Unfortunately, this often assumes a few things that aren’t likely to happen. For example, public pensions in B.C. usually calculate pension benefits at retirement based on you taking a pension on your life alone with a 10 year guarantee period (i.e. if you die in year 2 of retirement, someone will get a payment equal to the remaining 8 years of benefits you’re still owed.) If you’re married, you will probably look at a pension that pays 60% to 100% of benefits to your spouse on your death and which continues medical benefits. This alternative “form” of pension is a lot more expensive (its actual cost will depend on your spouse’s age and gender.) In other words, you’ll probably receive a lot less per month while you’re both alive than if you took the “normal form” single life 10 year guarantee pension. If this is the option you’re actually going to get, better to find this out now than when you’ve already bought your RV and are planning your retirement party!
On a brighter note, the calculations provided on most pension statements assume that you won’t get a raise between now and retirement. As discussed way, way earlier, many public sector pensions base your payments on an average of your 5 best years of earnings. This can mean that they are underestimating your benefits if you have many years before retirement and are expecting a couple big promotions along the way. To get a more accurate read on your future pension, many pensions offer pension calculator tools that let you enter a password, your own pension information pops up and you can do your own estimates of future earnings, while also learning what it will cost to buy pensions other than the single life 10 year guarantee pensions used to provide your basic estimate.
• Don’t Be Afraid to Mix and Match. Just when you thought things couldn’t be any more complicated, some pensions even allow you to select one pension option with part of your pension and another with the remainder. In my world, I prefer to keep things as simple as possible but sometimes there is a good reason to muddy the water. I recently came across one such case, where both the spouse with the pension and the non-member spouse were in poor health when it was time to select pension options. By this time, it was too late to commute the pension and take the cash value, and the longest guarantee period was 15 years. Unfortunately, if they took the single life 15 year option, this would mean that the non-member spouse would lose the medical benefits that went along with the pension if the member spouse died first.
On the other hand, while taking a joint and last survivor pension would continue benefits for as long as either lived, neither of them expected to be around for too many years and they wanted to leave as much as possible to their kids. The solution: taking 99% of the pension as a single life 15 year guarantee pension (the maximum available for that plan) and the remaining 1% as a joint life pension. This still provides a significant payout to the kids if mom and dad die shortly after retirement but ensures that the non-member spouse gets at least 15 years of payments and medical benefits for life, although he would get only 1% of the pension if he lived beyond the guarantee period. As a final note, since the plan automatically defaulted to a joint and last survivor pension if the member was on disability leave rather than on pension at death, the couple also needed to start the pension now in order to get the pension they wanted. As a final step, starting the pension meant losing group life insurance. Since there is the right to convert this to personal coverage if you act shortly after retirement, they planned on converting and paying the premiums personally in order to leave more for the family.
• Better Safe Than Sorry. When going over pension options closer to retirement, some couples lean toward single life pensions rather than joint life pensions. Unless there are compelling health reasons not to select the joint life option or the family has lots of other financial assets, I usually recommend taking the 100% joint life pension if it still provides the clients the desired retirement income; the single life option is often not dramatically different from the joint life option and, besides, it’s subject to tax in any event. In my view, a net difference of an extra $1,000 or two per year is seldom worth the risk of the non-member spouse outliving her spouse and the guarantee period by 20 years or more; as people generally underestimate their life expectancies if they’ve already made it to retirement, it is quite possible that one spouse could die within the first 15 years of retirement and the other eventually celebrates a 95th or 100th birthday. Since the survivor would already lose the deceased’s OAS pension and from 40% to 100% of his CPP pension when the survivor is over age 65, going without the work pension for an additional 20 or so years (as well as losing the extended health coverage that went with the plan) might convert the survivor’s golden years into something far darker;
• Stay Away From Pension Max. The life insurance industry has long offered a planning technique called “pension max” that typically calls for the member to select a single life pension (hopefully with a 15 year guarantee period) and to use the extra money to buy a permanent life insurance policy on the member’s life death to replace the lost pension benefits while still leaving behind a few extra bucks for the couple to enjoy together along the way. It is certainly possible that this technique can provide better results in some scenarios, such as if both spouses die early in retirement, the member spouse dies last or both spouses die shortly within the same time frame of each other. On the other hand, unless they plan on taking matters into their own hands, these results are rather hard to predict. Moreover, many calculations forget or gloss over the fact that the extra pension money generated by pension max is going to be taxed, which may significantly cut into the extra cash flow this technique is supposed to generate. As I want my retirement planning to provide more certainty that surprises, I usually prefer sticking with the plain old vanilla 100% joint and last survivor option that ensures that the pension cheques and extended health benefits keep on coming as long as one of the spouses still walks this veil of tears;
• Be a Careful Commuter. Sometimes it makes sense to convert the value of your pension into cash that you can invest and sometimes you should leave it alone and take your pension. Key factors include:
o how long until you can start your pension (the longer the wait, the better the case for commuting);
o size of your pension – if relatively small, commuting is likely better than getting tiny cheques each month. If small enough, it can all be transferred to a regular RRSP;
o whether your pension provides medical benefits and indexing that will be lost if you commute;
o your employer’s financial health and your assessment of its future;
o whether you will have to pay tax on some of the pension upon commuting or whether it can all be rolled into another registered plan. If the taxable portion is huge, then commuting usually makes no sense;
o how much of the money transferred can go into a regular RRSP or RRIF and how much must go into plans with withdrawal restrictions. Obviously, the more flexibility the better. Each province has its own rules. Moreover, if you work for the feds or a federally regulated industry like banking or transportation, federal pension rules apply instead of provincial ones;
o your health – if single and in poor health, or if you’re sick and married and your spouse isn’t a medical miracle, commuting may leave more behind for your heirs;
o investment expectations going forward. Are you willing to trade a somewhat sure thing for rolling the dice? Lots of people liked to commute during the tech bubble but not so many commute these days;
• A Bit of This, A Bit of That. There are a bunch of other options to consider that probably don’t warrant their own paragraph but are worth a few words in passing. They are:
o Learn How to Bridge. Many plans offer early retirement bridge or bridging benefits that are designed to pay until the member turns 65, which is the age we can start CPP benefits without a reduction. Learn whether they apply in your case. If so, be sure to remember that, even if you get a 100% joint and last survivor pension, the bridge benefits generally still disappear when the member spouse does. This can mean an extra unpleasant surprise for the surviving spouse if the member dies at after retiring at age 55 unless you’ve already planned for this shortfall;
o Disability Pension vs. Retirement Pension. Staying on disability rather than retiring may continue to pump up your eventual retirement pension and perhaps your CPP pension as well, but, as illustrated in the example provided earlier, sometimes it makes sense to start your pension early. What you should do depends on your individual circumstances and expectations, but it is definitely worth crunching the numbers;
o Learn About Giving A Little More. Some pensions are entirely employer-funded but also allow you to contribute extra money if you wish. This extra money is later used to turbo charge your pension and is 100% deductible along the way. Because of how RRSP and Pension contribution limits are calculated, this extra money (subject to limits) doesn’t chew up any more RRSP room. Accordingly, if you’re in a high tax bracket contributing and deducting some extra money now might make a nice difference when it is finally time for you to golf full time. Unfortunately, most employers don’t offer this option; and
o Pay for the Past. Sometimes, you may eligible to purchase extra pension time, such as when gone on maternity benefit. Although you will want to crunch the numbers, it is often a good idea to dig deep and buy back past pension service;
For many people, their work pensions are their largest retirement asset. Unfortunately, these pensions often seem like a mystery wrapped inside of an enigma written in a foreign tongue hidden inside of a crossword puzzle. Although finding the answers may require some detective work and a degree in higher mathematics, the results are worth it. Fortunately, most pension plans have very cooperative people just dying to lend a helping hand and lots of useful information for you to digest. There are also financial advisors who actually enjoy this sort of thing who can help you make intelligent choices and perhaps talk you out of rolling the dice when not necessary. In any event, regardless of whether you’re a lone wolf or like a little help along the way, the key thing is to start now. The retirement you save may just might be your own.