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The Million Dollar Journey and Defined Benefit Pensions: Are You There Already?

Regular reader, commenter, and personal finance enthusiast, DAvid, has shared with us some of his thoughts on how to determine the true “value” of a defined benefit pension.

As an avid follower of Frugal Trader’s Million Dollar Journey, and subsequent to some discussion on the topic, I began to wonder about where a Defined Benefit Pension (DBP) puts me on my personal MDJ.

The following is based on the Defined Benefit Pension Plan in which I am enrolled; most Canadian based government plans should be similar.

A recent article in Moneysense, indicated that about 50% of younger workers have a pension plan. An astounding 60% of Canadians over 55 have a pension plan, worth, on average $260,000. In most DBP, only member contributions and interest are reported to the member; the employer contributions are not reported in the annual valuation.

Many of these DBP, will pay up to 70% of the member’s then current income (or best 5 years income), and usually include a joint benefit to the spouse. This makes the actual value of the DBP much greater than the annual report would suggest. Since none of us know with certainty our lifespan, we all wish to ensure a large enough nest egg to provide us a comfortable living until death. We may also wish to leave an estate for children or other purposes. However, if the first goal of accumulating wealth is to provide for retirement income, how does a DBP stack up against a retirement portfolio?

For this example, the Canadian family average income of $75,000 per annum is used as a benchmark. The contributor(s) are 40 years of age, thus at a fairly stable point in their career. The following assumptions are made:

  • Inflation = 2.5%
  • Cost-of-living pay increases = 2.5%
  • Annuity investment return in retirement = 6%
  • Plan member contributes for 35 working years

Based on the amounts one would receive from a defined benefit pension, one would have to purchase an annuty in the following amounts to ensure income equivalent to a DBP until age 90:

Age Salary Pension Annuity Cost to Age 90 (6%)
40 $75,000
55 $108,662 $76,063 $1,575,000
60 $122,896 $86,027 $1,625,000
65 $139,046 $97,332 $1,650,000

Those who are fortunate to have a DBP are well on their way to their first million already, even if they choose not to maximize their pensionable time.

While you don’t actually accumulate this wealth, and do not have a large estate upon death, the member and spouse will have a comfortable, often indexed, pension as long as either lives. It is also realized individuals may not live to 90, but DBP are a form of insurance, whereby it is expected that some will have a longer claim period than others. If, on the other hand, one needs to build wealth individually for retirement, how long should you plan to ensure income? Current age expectancies for a 40 year old in good health, with a good family health history is 77 – 78 years, but many live longer! Is a 90 year lifespan sufficient in planning a financial future?

This certainty of future income allows one to make many other considerations as to the use of the savings accumulated through regular RRSP contributions, the creation of a non-registrered portfolio, or other investments. This could fund early retirement, educational opportunities, sabbaticals, or other options for an enjoyable lifestyle.

If you are a member of a defined benefit pension, what will you do with your second million?

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FT About the author: FT 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.

{ 8 comments… add one }
  • George August 14, 2008, 9:19 am

    There’s one fundamental flaw in the above table – it’s entirely based on average family income ($75000), yet the average individual income is in the range of $50000 – essentially, the above table assumes a two-income family where both earners have defined-benefit pensions. While possible, I don’t think this is the norm.

    With a base salary of $50,000, a 70% pension is of $35000 per year, which drops the “annuity-equivalent” value to a little over $600,000 (note that I’m using today’s dollars and ignoring inflation here). Still nothing to laugh at, but definitely not in the 1.5 million range.

  • MoneyGrubbingLawyer August 14, 2008, 10:42 am

    Excellent post, DAvid.

    I’m surprised that 50% of younger workers have pension plans, although my experience has been that more and more younger employees are looking for such benefits. A solid DFB pension plan was one of the major factors in my recent decision to change employers.

    The true value of a pension becomes painfully apparent in divorce proceedings where one party has a pension entitlement that isn’t divisible. The cost of paying out half the value of such a plan can be astronomical.

  • Xenko August 14, 2008, 12:08 pm

    Since the DBP (in government) is based on the average of the 5 highest salary years, looking at the average salary is not a good assumption to use. You would likely have to look at the average salary of workers who are older than 50, who would likely earn more than $50,000, since as a general trend, older and more experienced workers should have the highest salaries, while the younger entry level people will have a lower salary. You would also have to take out the data for people who are employed in positions without DBPs (older people working minimum wage jobs etc.)

    I think $75,000 is probably a reasonable assumption for a worker approaching retirement in a job that provides a DBP.

  • DAvid August 15, 2008, 1:15 pm

    George,
    This example was created to make a comparison to the suggestions of Financial Advisors, who suggest a sum one should amass prior to retirement. While two income earners each having a DBP is uncommon, it is not unheard of. In addition, in government and other providers of DBP there are many professionals earning at the $75,000 level. A professional with a bachelor’s degree earns about $65,000 or more in western Canada, and those with a Master’s level earn in or above the $75,000 range.

    The table is adjusted for inflation, before and after retirement. If recalculated based on your suggested income, would need a $1,040,000 annuity for a 40 year old retiring at 55.

    DAvid

  • Ed Rempel August 18, 2008, 12:09 am

    Hi David,

    Interesting article. To answer your title question, for most people, a full DB pension is not enough to retire comfortably – even after 30 years. The payout on a government pension plus CPP is about half of what the employee earned just before retiring. This is 30 years x 2% x the salary from the 3rd last year, less the spousal benefit cost. This amount includes the CPP payout.

    Even with no mortgage or kids’ costs, could you live the comfortable retirement you want on half of your current income?

    If only one member of a couple has a DB pension, then it really would be too little. A couple would probably need both to have full pensions.

    We have quite a few teachers as clients that retired on a full pension and then went back to work because the pension was too little and would be a big cutback in their lifestyle.

    You are right that those that have them rarely understand how much they are worth. I was unable to find the article you referred to, but it would surprise me if 50% of younger workers have a pension plan. Even if that is true, less than half are DB pension. Employers have been moving more and more towards defined contribution plans. Outside of government, crown corporations and teachers, there are hardly any very generous DB pensions available.

    Since people with DB plans usualy get hardly any RRSP room, they are prime candidates for the tax deductions from the Smith Manoeuvre, in order to top up their pension income in retirement.

    Ed

  • DAvid August 18, 2008, 11:59 am

    Ed,
    Thanks for your comments!

    A full DB Pension occurs after 35 years in the work force, granting 70% of the plan member’s then current income. Teachers may exit the workforce earlier, on average. This is a 16% increase in pension over claiming after 30 years.

    We currently live on about half our income, due to my aggressive payment of our mortgage, and other debt, and I am sure others are in the same financial position. The challenge, as you stated in an earlier post, is to avoid becoming comfortable with the increased disposable income that is available upon final payment of the mortgage, then to find you have a considerably reduced income after retirement.

    One of the points I was trying to make above, was not to simply be satisfied with a DBP, but to decide how to manage the additional options available to you with the remaining contribution room in your RRSP, or other investments. The DBP should provide for a basic retirement income, so you should plan for the other pre- and post-retirement goals you may have, to ensure you have a satisfying retirement.

    DAvid

    P.S. The article I referred was from this blog on August 5.

  • Cannon_fodder August 21, 2008, 10:07 am

    Ed,

    I would appreciate some insight into what your clients are seeking for their retirement income to feel ‘comfortable’. I’ve tried to anticipate what my wife and I will need and it will be around $36k/year after tax in today’s dollars. I’m crunching numbers assuming $42k/year after tax to be safe.

    It wouldn’t be fair in my case to compare it to current income since we have aggressive mortgage payments, maximum RRSP contributions, maximum RESP payments, paying for two braces and a large child support payment. Thus, we are not going to need the oft-quoted 70% of our current income on retirement in nspite of retiring early (without the cushion of CPP and OAS payments initially).

    I would imagine your clients tend to the higher income requirements only because I think that people who have financial planners have significant assets, and are used to a higher standard of living and the costs associated with that.

  • Don January 19, 2009, 3:15 am

    A couple of comments from a junior senior. Avoid divorce if possible because current property law includes a present value calculation based on, among other things, when you plan to retire. In the alternative, always tell your spouse that you plan never to retire or retire at 80. In my experience, dividing your pension will mean poverty on retirement. The alternative is to liquidate the house and cottage, keep the defined benefits pension and use any surplus as a down payment on a small house. By the way, you need $60k to give you $4k/month net of taxes, medical and dental insurance. Take the $4k and give one each to assist three University kids and that leaves you about $150 a month ahead of welfare benefits.

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