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The Risk of a Defined Benefit Pension

A government based defined benefit pension is considered the gold standard of retirement benefits.  The requirement is that you need to work for the government for 25-30 years, contribute a small portion of your salary towards the pension and in return, you get 60-70% of your working income monthly (some pensions are even indexed to inflation) during retirement.  It really is a great deal for employees willing to stick it out with the same employer for their careers.

The Risk of a Defined Benefit Pension

While defined benefit pensions are a great deal for employees, it is an extremely expensive benefit for employers to offer.  With these pension plans, the risk sits with the employer whereas with a defined contribution plan, the risk is reverted to the employee.  However, that does not mean that plan members do not face risk. Perhaps the greatest risk that a defined benefit plan member can face is a large unfunded pension liability.  While pension bankruptcy may not be that likely with a Canadian government based pension, changes to the plan to make it sustainable can significantly impact retirement plans.

In fact, there were recent changes to the Newfoundland & Labrador pension plan because of the unfunded pension liability that has affected thousands of employees, yours truly included.  While I’m not vested into the plan yet and do not plan to be working for another 25 years, it still does impact my future plans.  The changes include an increased contribution requirement from employees, increased working requirement to qualify for retirement benefits, and changes to the deferred pension status.

How to Reduce the Risk

For new government employees just starting out with a long career ahead of them, there is a risk of further pension changes.  While many young employees who are vested in a defined benefit pension believe that the pension will take care of them, my thoughts are that risk should be reduced by supplementing the plan.  Future defined benefit plan changes cannot be controlled, but saving and creating your own pension for retirement can be controlled.

Once you’ve made a plan to squirrel away some cash flow, the next question is where to put the cash.  For people with a defined benefit pension, I would suggest to put the money in a TFSA.  Why not an RRSP?  The reason is that pension payments during retirement are taxable and RRSP withdrawals would add to the income tax payable.  The additional income could also impact seniors benefits.  TFSA withdrawals, on the other hand, are not taxable, and do not affect seniors benefits.

If starting this year, maxing out your TFSA and passively investing the proceeds for the long term would result in about $218,000 in 25 years (assuming TFSA max is $5,500 per year and adjusting for inflation with a 3% return).  Using the 4% withdrawal rule, results in a tax free supplementary income of $8,720/year.  If retiring as a couple, that figure doubles to $17,440/year tax free.

Take care of your own retirement and you’ll just brush off the future changes that your employer makes.  For those of you who have a defined benefit pension, are you supplementing your retirement with other investments?

 

 

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FrugalTrader About the author: FrugalTrader is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 19 comments… add one }
  • SST September 9, 2014, 9:46 am

    Fact is, approx. 80% of pension funds are underfunded, thus reliance on these incomes faces very real risks. I work for the government and am forced to contribute, but built-in self-reliance forces me to save and invest in Pension 2.0 (which also forces me to live that much extra below my means).

    Secondly, and as has happened in various countries around the world, including Canada, is the dreaded pension reform (within my first year I experienced reform). Sad as it may be, I view my contributions as money kissed good-bye, simply because I have zero control over it and it can quite literally be taken away from me at any time.

    Times have changed, it’s a different game these days and it’ll be crappy for more than a few people when the music stops.

  • Robb Engen September 9, 2014, 10:04 am

    I work for a University and I’m forced to contribute over 11 percent of my salary to a defined benefit pension plan that will undergo massive reform by the time I’m eligible to retire. So, yes, I absolutely save outside of my plan so that I can at least have the option of early retirement subsidized by my RRSP and TFSA – http://www.boomerandecho.com/save-outside-defined-benefit-pension/

  • Mitch September 9, 2014, 11:33 am

    I have been in the military for 15 years and have 10 more to go before I’m eligible to receive an immediate pension. I’m not 100% confident in the pension and I may release before I can receive it. Both my wife’s and my own RRSP and TFSA’s are maxed out as well as our son’s RESP. We save so much that we have to use taxable trading accounts. As MMM puts it, we have “F-you money.” That way, if the miltary tries to send me somewhere I don’t want to go I can put in my release and walk away with the commuted value of my pension and our F-you money and be done with it.

  • Vince September 9, 2014, 4:33 pm

    I work for the government but am putting money aside as if the pension won’t be there. It is currently all in my TFSA and non-registered account which is about 30% of my net income.

    Our pension is underfunded and we hae already increased our contributions once. Won’t be the last for sure.

    The biggest thing I really care about is the health/dental plan we have. That is what I will care more when I get old and retire.

  • tom September 9, 2014, 6:04 pm

    scary thing is, even with all the reforms and changes, many people wouldn’t have a “pot to piss in” if it wasn’t for their DB plans, but sadly many people were sold a bill of goods in which the current system can no longer support. On the other hand , if people don’t like the idea of contributin 11 % to something they don’t control, get a new job lol. the pension is just part of your compensation package. start looking for a new job if you dont like it haha i think many people dont realize that not a single pension in canada is guranteed, just the 1000/month if it is registered in ontario. very little education around db plans

  • Sean Cooper, Financial Journalist September 9, 2014, 7:19 pm

    Great post, FT! You know what the real kicker is? If your pension plan goes belly up, you don’t get your RRSP room back for all those years you received a Pension Adjustment. Talk about unfair!

    Changing demographics make pension plans challenging today. With so many boomers retiring, today’s workers are going to have to contribute even more for their pension. When us younger workers retire our benefits won’t be as good as the last generation. It doesn’t seem fair, but as you said, that’s why you need to contribute to your TFSA.

  • My Own Advisor September 9, 2014, 8:01 pm

    I work for a national, not-for-profit organization that has a DB pension.

    I suspect, like Robb, the pension might be overhauled at some point.

    So, yes, we max out our TFSAs even though I have a DB pension and my wife has a DC pension. We both have about 13 years into each plan.

    We also contribute to our RRSPs although we don’t max the accounts out each year with contribution room. My RRSP though, might be maxed out by 2016. My wife has tons of contribution room.

    The way I see it, if I have a tax problem in retirement, this is a very good problem to have.

  • Jay @ ThinkingWealthy.com September 9, 2014, 10:20 pm

    Great post. I’ve never come across these before and the terror is real! Good luck to all of you guys that have one given the overhauls coming.

    Jay

  • Dan @ Our Big Fat Wallet September 10, 2014, 12:07 am

    I don’t have a DB but if I did, I’d be concerned about what the future may hold for the plan. I think the ideal scenario is to have income streams spread out over multiple investments such as RRSP, TFSA and possibly rental income so that you don’t have to rely on government programs like CPP

  • George September 10, 2014, 12:39 am

    Nice to see a post dedicated to people with DB plans and who work in government. A lot of blogs don’t focus on public servants. Thanks FT. Not only does having a DB presents risks, having a DB impacts savings decisions. I work for the federal government, and I have colleagues who say that they don’t contribute to RRSPs or TFSA because of our pension plans. Most of my friends and colleagues put their money or extra savings into their mortgages.

    I don’t. I’ve been educating myself on saving and investing and make sure to save and invest outside of the pension plan. Mostly because I want some control over my future. This might sound strange to some readers but I find the pension to be a bit of a trap. You have to put in 25-30 years to get access to that the (generous) pension payments. This impacts lifestyle and investing decisions.

    I’m saving for a down payment on a house, max out my TFSA, and after that, I consider my RRSP (even though I have little RRSP room because of the pension adjustment).

  • Cold Truth September 10, 2014, 11:19 am

    Sean Cooper hit the point that a lot of people tend to forget about. Let’s say you have a a fairly generous pension plan where your employer ponies up quite a bit.

    Your RRSP contribution room is reduced by the sum of yours, plus your employers contributions. And if the employer is making big fat contributions on your behalf, that eats up nearly all of your contribution room.

    Here’s the problem. The RRSP contribution room is deducted based on your employers obligation, not the actual money they put in.

    If the employer is underfunding the plan, you lose contribution room on money that may never have gone into the pension, then when you go to collect decades down the road, your benefits are reduces or gone.

    Recognizing this risk and saving for yourself is a great idea! But with all your RRSP contribution room gone you’ve got a much harder time than everyone else!

    If a defined contributino plan, this whole situation is avoided. The downside is you won’t be able to get benefits that far outweigh what you fairly deserve, which is how defined benefit plans operate.

  • Cold Truth September 10, 2014, 3:01 pm

    I should clarify that there is a difference between the employer not having the cash flow to keep up with it’s required contributions (which I referred to above) vs the pension plan itself simply not having enough money to meet its obligations despite all contributers being fulling paid up.

    The former is rare but does happen when a company is heading towards bankruptcy and has cash flow problems.

  • Steve September 10, 2014, 6:23 pm

    We are both part of DB plans but not the same ones, so perhaps some slight DB PP diversification, haha.

    I remember requesting to look over all financial documents and it was a bit of a pain in the ass getting them even though I am allowed to request once a year. When I check it last in 2012, the actuarial report was from 2010 and it was 83% funded. I think the number has crept up into the high 80s since the last valuation.

    However, I am still uneasy about it. I would gleefully take the commuted value if/when I leave and place the funds in a LIRA.

    Like you and many others in the comments, we also save and invest at a high rate just so we don’t have to rely on something/someone else.

    At least in a federal government pension plan, the government can always just raise taxes or divert tax money to fund the promises they made?

  • Francois September 10, 2014, 9:14 pm

    I had this exact conversation with my director a few years ago. He told me I did not need to save much for retirement, because in the federal public service, we have a great pension plan. Well, I told him, that NOW, we have a great plan, but that the governement, especially the conservatives, can change a lot of things over the next 25 years before we retire. So, because I’m Lucky (or educated and talented enought) and I am a senior analyst earning $100k, I can still manage to max out my RRSP (I’m allowed to put like $4,000 in it every year) and my TSFA.

    But I still think the defined pension plan is better for the vast majority of the people. With the current rules, at my current salary, it basically cost me 8,000$ a year in contribution, for 30 years, to get $60,000 a year afterward. I would need to make something like 9% every yeart for the same $8000 a year invested during 30 years to get something similar. Not sure I’ll be able to make 9% consistently over 30 years. And if I was to retire in 2008 or 2009, I would have faced huge loss just before retirement…

  • Ed Rempel September 10, 2014, 10:00 pm

    Hey FT. Interesting article.

    Opportunities if you have a DB pension and want to build wealth are there. Most people with DM plans tend to be conservative and would have little without them. There are some wealth-builders with DB pension plans, and it can be a drag for them.

    Here are 2 opportunities if you are a wealth-builder in a DB pension:

    1. With today’s low interest rates, pension valuations are quite inflated. Commuting your pension by quitting your job and transferring it to a locked-in RRSP can be very beneficial. Pensions give you a guaranteed income, but assume 4-5% returns long term, offer only a fixed income and there is nothing left for your heirs. Commuting for a good investor can mean higher retirement income, more flexibility of when to take your income, ability to unlock half to a regular RRSP, and your spouse and kids get 100% of what is left when you are gone (vs. 60% for spouse and zero for kids with a pension).

    2. People with a DB pension have very little RRSP room and little opportunity for tax deductions. They might be excellent candidates for the Smith Manoeuvre. That gives them a tax deduction and a way to build wealth that is probably more effective than TFSAs for those with a DB pension.

    Ed

  • A Frugal Family's Journey September 12, 2014, 2:48 am

    Nice post…couldn’t agree with your more. I am a government employee who is hoping to receive a pension well into retirement. But seeing the unfunded liabilities that many cities are facing here in California, I refuse to leave my fate and my family’s well being in the hands of my employer! That is why I also contribute to a 457K, invest in a Roth IRA, invest in dividend stocks portfolio, invest in Peer-to-Peer lending notes, etc. I want to make sure I have plenty other sources of income I can also rely on in case something happens to my pension. Thanks for sharing! AFFJ

  • SST September 12, 2014, 10:02 am

    @AFFJ — how are those P2P notes working out for you, and how much of your portfolio is dedicated to them?

  • Jay in Calgary September 14, 2014, 10:50 am

    I just left a job in private sector with DC pension and took a position at a college with a DB. All talk is how much better the pension is but I still feel better with the DC. I like how money and performance is in my hands. I pay a large % into DB every check, and although it may be a better plan at this point I have no control over the $ or over any changes in the future. I feel as I’m paying for older colleagues retirement and mine will cost even more in future (I am mid 30’s). I realize I can leave at any time but I really love this new career choice. As for now I’m treating the DB as the conservative part of my portfolio, and I have decreased fixed income holdings in my RSP and TFSA.

    Great article keep them coming.

  • MS Barbour October 29, 2014, 2:09 pm

    Beginners with DB plans should be aware that you have to put in a lot of years before you get that so called “gold plated” pension. Not many people end up being in the same job for 25-30 years, but when DB pensions are discussed, the figures used often assume the employee will do that. Tough to commit to a lifetime of working for one company when you’re young!

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