The Fundamentals of Pensions | E002
Full Transcript:
Jason Pereira: Hello, and thank you for joining me for the Wisdom of Wealth, a show where we help educate Canadians about fundamental financial literacy topics, and to help you make better and more informed decisions, and to know when and where to reach out for help.
Jason Pereira: I'm Jason Pereira, and I have the privilege of being your host. Today on the Wisdom of Wealth, we are going to talk about something that affects the lives of over one-third of working Canadians, workplace pension plans. Workplace pension plans are put in place by employers as a way to attract, retain, and reward employees, while simultaneously helping them prepare for retirement and doing so in a tax- efficient manner.
Jason Pereira: In Canada, over six million Canadians are part of a workplace pension plan and they could be the cornerstone of those employees' retirement. If you don't have a workplace pension plan, don't worry. We will cover RSPs and TFSAs in a future episode, and tell you how you can build your own. But now, let's go back and talk about pensions.
Jason Pereira: Pension plans vary in rules, structures, features, but there are essentially two major types. Defined contribution and defined benefit, so let's start with defined contribution plans. These are the most common forms of pension plans. Over two-thirds of pension plans are defined contribution plans. In addition, many employers who don't offer these types of pensions will offer a group RSP plan that looks just like a defined contribution plan in most ways. With defined contribution plans, or DC plans for short, your employer sets guidelines on how much they will contribute to your retirement savings, hence the term, defined contribution.
Jason Pereira: With DC plans, employers and employees contribute to an investment account. There is a formula established that determines how much an employer will put into your DC plan and it typically is based on how much you put into the plan. For instance, they may match your contributions, dollar-for-dollar up to a percentage of your income. Say 4% of your income that you contribute is matched by 4% of what they put in. I urge all of you to make sure that you're contributing enough to your plans to get all of the money that your employers are offering you. Not maximizing your employer matching is one of the most common mistakes we see. Combined, you're both able to contribute up to your RSP limit, which is 18% of income per year up to a cap, plus any unused room.
Jason Pereira: Contributions made to a DC plan do not attract taxation. The funds within a DC plan can then be invested as you see fit, and grow tax-sheltered. That is to say you don't pay tax while they're in there in these accounts, enabling your retirement savings to grow faster.
Jason Pereira: The number of investment options you will have access to depends on which company is administering your pension, but typically you will have access to interest accounts, GICs, mutual funds, and index funds. Most people don't know what to choose and often invest too aggressively or too conservatively. This is where speaking to a financial advisor can help, either a current advisor or one provided by the plan administrator. These people can help you guide your decision on where to put your money. In the end, you should be investing in a diversified portfolio that is no riskier than you can tolerate.
Jason Pereira: Many people often ask, what happens if I change jobs? One of the great things about DC plans is that they're portable. That is to say you can typically transfer into another pension plan or to an account with your financial advisor, and continue to manage the money going forward.
Jason Pereira: In most provinces, you cannot access your funds in your DC plan prior to age 55. After age 55, you have two options. You can convert your plan to a life income fund, or LIF for short. This is an account that's similar to your pension, but with two differences. No additional contributions can be made, and you need to take money out every year. How much? Well, that's the term of something called the RIF schedule. A RIF or a registered retirement income fund is something that your RSP converts to you in the future, and the government sets a schedule that basically applies to LIFs as well. The amount that has to come out is a percentage of the total account value determined by your age. You can take out more, but there is also a maximum percentage that you can take out based on age. Basically, the government wants you to take it out slowly to finance your retirement and not all at once.
Jason Pereira: Now, the second option is in many provinces, you have the option to unlock all or part of your pension plan and put it under your control. The rules on this vary from province to province. But in Ontario, you can transfer up to 50% of your pension to an RSP, where there's no limits on how much you can take out. It's important to note that all withdrawals are fully taxable, and it's also important to note that the amount scheduled to come out will change every year and will depend on how much you take out the previous year, and what your portfolio's return is and your age.
Jason Pereira: The second more traditional type of pension plan is a defined benefit pension plan, also known as a DB plan. These types of plan are becoming less common, but are what most people think of when they think of a pension plan. The goal of DB plan is to guarantee an employee a set amount of income in retirement. The way they do this is with a formula. For every year that the plan member works for that company, they earn up to 2% of their best, last or average of their three to five years of income. Clearly, there is a lot of math involved here, and that's why they involve actuaries. But just like a DC plan, employers and employees both make tax-deductible contributions to the plan. But unlike a DC plan, these are mandatory and the amounts are set based on percentage of your income that is set by the actuary.
Jason Pereira: Funds invested in the pension are tax-sheltered just like a DC plan but unlike the DC plan, the pension is invested on your behalf by the pension administrator. There are various advantages to this. First of all, you don't have to worry about running it yourself. Secondly, running one large pool of assets is more cost-effective than all of these separate accounts. And if the pension fund fails to return what they were supposed to in the marketplace, then the employer is actually obligated to cover the difference.
Jason Pereira: At retirement, you'll be given several options for how you can take your pension plan. We're going to explore these in greater detail with our guest later, but most pensions start at age 65. However, most pensions also allow you to retire early. In most cases, this will result in you receiving less from your pension for life than you would have had you waited until 65. The earliest you can start receiving income from your pension is age 55. Some pensions also offer something known as a bridge benefit. This is a benefit where if you retire before 65, you'll receive an additional benefit equal to roughly what Canada Pension Plan would have paid you went you start taking at 65.
Jason Pereira: Now, let's take a closer look at the options available to you when you retire with a DB plan. And to help discuss this, I have financial planner, author, and pension expert,
Alexandra MacQueen, in the studio with me today.
Jason Pereira: So Alexandra, thank you for joining us today.
Alexandra MacQueen: Thank you.
Jason Pereira: Why don't you tell us a little bit about what it is you do for a living?
Alexandra MacQueen: So my company name is called Pension Acuity Partners, and I'm really just focused on helping people make decisions about their pension.
Jason Pereira: Excellent. When somebody is ready to retire from a company with a defined benefit pension plan, they will typically receive a document that explains what options they have and this is kind of strange to some people because they've always seen if I retire, I'm going to retire with X, but they didn't probably factor in these options. So what are these options they're being given?
Alexandra MacQueen: Well, Jason, generally speaking, there are four options that a member of a defined benefit plan might have at retirement.
Jason Pereira: Okay.
Alexandra MacQueen: So of course, one option is to stay in the plan and receive the pension as set out by the plan document.
Jason Pereira: Exactly what they were expecting, most of the time.
Alexandra MacQueen: Right.
Jason Pereira: Yeah.
Alexandra MacQueen: And for many people, that's what they expect. When they join the company, they think I'll work here as long as it takes to earn that pension and then I'll retire with a pension. And what happens is that effectively their work paycheck just seamlessly translates into a retirement paycheck, although it will be smaller.
Jason Pereira: So great, so they have the option to basically stay in the plan, which is what most of them plan on. But even when they have that option, there's options for that option.
Alexandra MacQueen: Absolutely.
Jason Pereira: So it's not just here is this sum you're entitled to, but hey, here's a couple other factors that are going to impact that. So what are the factors that change the amount they can get?
Alexandra MacQueen: Well, the change in the amount they can get. So if they don't want to stay in the plan, one option is if they want to continue working, they may be able to transport that plan or their entitlement under that plan to a new plan. So for example, I'm working at company A, it has a defined benefit pension plan. I am eligible to retire from that company. I take my pension, and I go and join company B and I move my pension to company B. Now, that option is contingent on company B having a pension plan to which I can transfer my entitlement from company A, but that's a scenario where the person isn't in fact ready to retire.
Alexandra MacQueen: Another option is to take that pension and do what's called commute it. So commute in this context means stop. So I'm going to take the value of the pension that I've built up over my years working at the company, I am going to commute it and here is where it gets interesting because there's many options for commuting to a pension. So I can commute it to cash is one option.
Alexandra MacQueen: Now, when I do that, the amount that can be tax-sheltered is subject to limits set by the Income Tax Act. So let's say that my pension entitlement that I've built up when I get a commuted value for it is $750,000, which is...
Jason Pereira: Which, honestly, earning a regular working wage, they may not realize it but that's how big it can become retirement age.
Alexandra MacQueen: Which is part of the reason why this decision is so difficult because it's probably the largest single decision that somebody would make in their lifetime, the largest single financial decision.
Jason Pereira: Or maybe even more than buying a house in some cases.
Alexandra MacQueen: Well, and not only is it the largest decision financially, but it's a decision that can't be undone. So I you...
Jason Pereira: [crosstalk 00:10:02] has the biggest impact on your retirement, right?
Alexandra MacQueen: You can't commute and then say I change my mind, I want to go back into the pension plan.
Jason Pereira: No.
Alexandra MacQueen: So I've decided to commute my pension. I don't want to stay in the plan.
Jason Pereira: So you're taking the cash and running, essentially.
Alexandra MacQueen: That's right. I can take the cash. Now, what happens with that cash? Part of it is going to get transferred. In fact, must get, according to income tax rule, transferred to a locked in retirement plan.
Jason Pereira: So like we recently talked about.
Alexandra MacQueen: Right.
Jason Pereira: A locked-in plan, it looks like a defined contribution plan and then it's going to be subject to maximums and minimums, when they start taking money out.
Alexandra MacQueen: Right, but it's also subject to maximums and minimums when they're transferring that money over from the entitlement. So in order to keep the playing field level between the people who have RSPs and people who don't, people who have defined benefit pensions, I can only transfer some portion of that commuted value to a locked-in plan. The rest, I have to take as cash and it's taxable in the year that I take it.
Jason Pereira: So that's an interesting point. So one thing that most people don't realize is that people with defined benefit pensions actually have more money [inaudible 00:10:59] put away than people with just RSPs or defined contribution plans, which is an unfortunate advantage but it's what it is and that when you want to leave that plan, as you said, the government equalizes that. We've seen cases like this where people who've earned 50, $60,000 a year are hit with a $300,000 income tax bill, or income tax...
Alexandra MacQueen: [inaudible 00:11:22] tax.
Jason Pereira: [inaudible 00:11:24]
Alexandra MacQueen: Yeah.
Jason Pereira: Okay. And we've seen cases like this, where people who have earned 50, $60,000 a year for their lifetime are hit with $300,000 added to their income and a tax bill over six figures and this can be quite shocking if they don't get educated properly as to what the implications of that decision are.
Alexandra MacQueen: And another side point that's very important is it's only their lifetime retirement benefit that can be sheltered. So you mentioned earlier, the bridge benefits.
Jason Pereira: Yes.
Alexandra MacQueen: That can never be sheltered.
Jason Pereira: Yeah.
Alexandra MacQueen: So if the commuted value includes for example, your lifetime retirement benefit, starting when you retire or age 65, plus a bridge benefit, that bridge benefit, if you commute it, the entire amount is going to be taxable.
Jason Pereira: Okay. So we talked about three general options already. So we talked about taking the income.
Alexandra MacQueen: Mm-hmm (affirmative).
Jason Pereira: We talked about transferring it to another pension if you continue working. We talked about taking the money. So before we go to the fourth one, I want to go back to the first. So typically when someone gets this and says, hey, you're entitled to this much money, however, do you have a spouse? Do you want that spouse to receive some of this money when you pass away, or do you want a certain guarantee that this is going to pay out for a certain number of years? So let's talk about both of those options and what the impact on those options are on the amount you receive.
Alexandra MacQueen: Right. So what you're talking about essentially is guarantees on that income.
Jason Pereira: Yes.
Alexandra MacQueen: So it's guaranteed to a spouse should the plan member predecease them, or it's guaranteed for a certain number of years should the plan member die before those years have elapsed. Now, the thing to keep in mind is that guarantees cost money. So every time you add a guarantee to an income stream, what you're doing is reducing the monthly payments. So for example, if I say, well, I would like to ensure that payments are made for 10 years, even if you have passed on if I am the plan member, then what that means is that each monthly payment will be a bit smaller than if I didn't have that guarantee.
Jason Pereira: So I'm entitled to $4,000 per month without that guarantee for life and if I want this guarantee for we'll call it 10 years, then basically I'm probably going to get something in the neighborhood of let's call it 3,700, just as a rough number.
Alexandra MacQueen: Sure.
Jason Pereira: That can make a lot of sense because it can... Sometimes it does and sometimes it doesn't and the reason is because none of us like the idea of, hey, I'm ready to retire. My pension just started, and I got hit by a bus. And now, all that money I put into it, no one gets that, right?
Alexandra MacQueen: That's right.
Jason Pereira: Where the guarantee with the guarantee in place, what it does is it makes sure that even if I'm not married, it's going to somebody.
Alexandra MacQueen: That's right.
Jason Pereira: Well, even if that person dies, it's going to somebody else for those 10 years. So I think I understand why that is. It gives people solace in saying, well, I put money in this for so long, I don't care who it is. It's me if I'm alive, but if it's not, someone else, and we're going to get something out of this.
Alexandra MacQueen: It really depends on whether or to what extent the plan member has an estate motivation, so it's really a financial planning question. So if I don't have anybody that I want to leave money to or I don't have any dependents, maybe I am content to have this pension provide income as long as I am alive and nothing left over. So in that case, I want to maximize the income while I am alive.
Jason Pereira: Yeah.
Alexandra MacQueen: And you also went spousal, essentially what's a joint annuity or a joint pension. So if I am married or have a common law spouse, then I have the option of ensuring that should I predecease them, some portion of my pension, it's usually 66% will continue to them for as long as they are alive.
Jason Pereira: So first person who [inaudible 00:14:45] the plan is receiving 100% of what they're entitled to. So originally it was 4,000, but you know what? I want my spouse to get two-thirds of this. So now, I'm going to take 3,200, for instance.
Alexandra MacQueen: Right.
Jason Pereira: So I'm going to take 3,200, I keep working. Eventually, I pass away. Well, I keep retiring. Eventually, I pass away and then my spouse is entitled to 60% of that 3,200. Now, what other options are there? Can I get more?
Alexandra MacQueen: No. So you can never get more. You can only get the maximum of what you're entitled.
Jason Pereira: No, but my spouse, can my spouse get more?
Alexandra MacQueen: The options will be set out in the plan documents, and it varies from plan to plan. Some plans say it's 60% for the spouse. It's very common that I see 66-and-two-thirds percent. I haven't actually seen more than that, but I haven't seen every plan in the world.
Jason Pereira: I think I've seen one where they get to 90%, and it makes sense, right? Because the entire belief is that two people, it doesn't take as much to support two people as it does one, but we also have overhead. We all, one house, still the same. We still have certain costs like the utilities aren't going to drop by that much, so it doesn't make sense that it's 50 but the question of where it should be is a financial planning question.
Alexandra MacQueen: So if to the extent that the plan member has choices, then yes, it is absolutely a financial planning question about which option is best.
Jason Pereira: Okay. So let's talk about the fourth option, this is an interesting one because this is one that almost nobody knows about and we know about it quite well because you wrote an article in The Globe and Mail that I was cited in, and myself and other people you know, we've done some of the first of these in Canada. What is this mystery unknown fourth one?
Alexandra MacQueen: So if someone goes out and Googles, what are my options at retirement with a DB plan? Mostly, you'll see articles that will say you can commute it to cash, which we've already discussed or you can stay in the plan. But there is in fact this other so-called mystery option, they call it what's called a copycat annuity.
Alexandra MacQueen: So recall that there's a limit on how much can be tax-sheltered if you commute to cash. So maybe I'm facing a tax bill of $100,000 or even $200,000 or more, now the money that I am investing to produce that income in retirement has to work even harder. I have to take more risk to try and replicate the income I would have received under the plan.
Jason Pereira: That's true. So taking the option for the cash, paying the tax bill and financing retirement means that you need to get a higher rate of return than the pension would have.
Alexandra MacQueen: That's right. It's implicitly more risky.
Jason Pereira: Yeah.
Alexandra MacQueen: So what if I don't want to stay in the plan, but I also don't want to face that tax bill and maybe I don't want to manage the money myself? There is an option to take the commuted value and move it over to an insurance company that provides... That matches the same benefit that the pension would have provided and that's with a life annuity, and this is called a copycat annuity because the life annuity copies the provisions of the defined benefit plan.
Jason Pereira: So essentially, we consider this, the pension companies or the pension itself is saying, hey, take this income or take this money. It's kind of an offer, right? They're basically saying this is how much this income is going to cost, and what we're doing with the copycat is we're going to an insurance company and saying can you beat their offer? Can you give us the same income for a lower amount? So for example, the example you gave with 700,000 commuted value, maybe 200,000 that will be taxable. We can get into a scenario, I've seen them happy before, where we can get the same income maybe for 600,000. So person gets the same guarantee of income and basically at the same time still gets 100,000, so I like to say it's a nice little having your cake and eating it too. You get to have the money, but you also get to have the income.
Alexandra MacQueen: Well, whether or not you get any excess refunded back to you, the point is that if you're reluctant to stay in your pension plan, you're worried about the long-term prospects for your company in Canada or just the long-term prospects for your industry, you may say I don't want to invest the money. I don't want the tax bill. I really would like the pension that I signed up for, or the idea that I signed up for when I joined the company. I'm going to take my commuted value to a nicely capitalized insurance company, which I am confident will make the pension payments for as long as I am alive. And the very important point, just to reemphasize is this is not taxable. So I've got this large entitlement, maybe the largest financial decision.
Jason Pereira: [crosstalk 00:19:01] to transfer, but when the money gets to paid to you, it's taxable.
Alexandra MacQueen: That's correct. Yeah, but it moves over without any tax. So unlike the commuted value where it's likely, if we're talking at the end of my working career, it's very likely that some portion of that will be subject to tax.
Jason Pereira: So it's an important point you made there, right? Because when you think about it, someone retires at 55 from a non-government pension and they choose to the income. As I said, if the pension performs, the employer is on the hook for the difference. But now, we're counting on with life expectancies being into the 80s and 90s, right? You get to live to 85, 90, that's a long time if you retire at 55 to count on your employer being around when the world changes [crosstalk 00:19:41]
Alexandra MacQueen: That's right.
Jason Pereira: Right? So I fully understand why people want to leave these. We see this happened a lot in the auto industry, specifically. So what are the key factors that people need to consider when they're contemplating? If they want to, if they continue working, you want to transfer the pension. That makes sense, right? That's a pretty straightforward option. But when it comes to the differences between taking the income, the copycat annuity, or taking the cash and commuted value, what are the key considerations people need to make?
Alexandra MacQueen: Well, the first one is for me, it's how comfortable are they managing them? Because if they're going to commute to cash and manage those funds, how comfortable are they doing that, given the size of the sums that we're talking about and their experience with managing money? So if you've been working in a defined benefit environment, you have had very little RSP room, usually. So it's very common that somebody arrives at the retirement age, if they have a large defined benefit entitlement, they don't really have a ton of investment experience. And if this is the primary source of retirement income, how comfortable are you, either whether it's finding an advisor that you trust or managing itself, do you want to take on that risk yourself?
Jason Pereira: Yeah. You getting to age 55, 65, and you've never invested before, is this the time to start getting in the game? And I will say also I often quite frequently say that this is a massive conflict of interest for advisors. You go to a financial advisor and you say, hey, what should I do with my pension? The advisor looks at option A and option B, and option A says I make nothing because you're getting income, I can charge you on fees on this investment money. Oh, I can do it. Oftentimes, it's like I can get a better return. Well, it's not about return. It's about supporting the client's goals, income, estate, whatever they are.
Jason Pereira: So even because of this conflict, what we tell clients when they come to us with this is I say, look, I'm a nice guy. I'm trustworthy. I'm going to tell you what the right answer is, but you shouldn't take my word for it because I am conflicted. So not that I feel conflict, but am in a position of conflict. So we often refer them out to people who don't invest with money, such as yourself or actuaries to give an independent third-party piece of advice and this might cost several hundred to $1,000, but we're talking about decisions that impact assets from hundreds of thousands to millions of dollars. This is an affordable solution to make sure you're getting the best possible option.
Jason Pereira: So for those of you out there who are facing this decision, yeah, talk to your advisor, but also make sure you get a third-party opinion of someone who is qualified, who does not sell investment assets because that is a massive conflict. So before we close up, any final thoughts as to basically what the most important considerations are for people when they're looking at [crosstalk 00:22:15]
Alexandra MacQueen: Well, I talked about how much risk you feel like taking on and how experienced you are with investing, but I think another thing is this generally just know yourself. If you got a $500,000 injection of cash into your bank account, would you then be tempted to say, okay, I'm going to help both of my children with down payments. My daughter wants a destination wedding. I'm going to pay. The amount of money can shrink very quickly because it occurs like a lottery win and we don't have any experience managing these large sums coming in.
Jason Pereira: Yeah, it is. We've seen studies that show that people don't understand the value of what guaranteed income is for life. In fact, when they're asked, how much do you think this would cost to buy? They're usually 30% lower than what it is, so it seems like it's more than they've ever had in their lives. Also, I think on top of know yourself, on top of that concept it's if you're the guy who is a smoker and you're single, and you've had three heart attacks, you're not getting to 95 in most cases. So in which case, are going to be around to receive all that income?
Alexandra MacQueen: That's right.
Jason Pereira: The pension income is probably better. Now, if you're like my wife whose grandmother died at almost 101 and she's part of the pension, I think it makes a lot of sense to take the income because that's probably, knock on wood, going to pay for a very long time. So thank you for taking the time to come in and talk about pension options.
Jason Pereira: So that was today's episode. I hope that we helped you understand more about pensions and how to make better decisions around them. Before we go, I wanted to remind you that we invite you, our viewers, to reach out to us with questions that you have about your own personal financial situation. I will be happy to answer them on-air. But don't worry, we'll keep your real names out of this and preserve your privacy. So thank you again for joining us for the Wisdom of Wealth, and we hope you will join us each week to seek to improve your financial literacy and help you live better lives. Until next time.