The Great Pension Experiment Part I: BackgroundPosted: November 20, 2016
This is part 1 in a 3 part series I have entitled "The Great Pension Experiment". This will detail my analysis on what to do with a defined benefit pension plan payout, after leaving my previous employer.
Up until 2015, I worked for the OPSEU Pension Trust, a major pension plan in Ontario, and had the benefit of a “golden pension”, or a Defined Benefit Pension. These pensions are considered the gold standard in the pension industry because the total payment that one receives upon retirement is guaranteed, regardless of what happens in the markets.
However, towards the end of my tenure at the company, a new CEO came in, and there were a number of changes with upper management. As a result of these changes, there was a large amount of restructuring as the company made attempts to streamline processes and change the long term strategic goals and organization of the firm. As with any restructuring, there are causalities, and my department was no different: my entire department was explained away, and I left the organization.
Due to pension law in Canada, when an employee leaves a company, they are given three options with the money that is with the company for their future pension:
- Leave the money with the company, and at age 65, start taking a pension.
- Transfer the money with the company to your new employer’s pension plan. In this way, any deductions which were taken off of your paycheque whilst with employed with the former company, would carry forward with you to your new company. The caveat to this is that it is not the actual deductions which would transfer, but the commuted value of those deductions.
- Transfer the commuted value of your pension to a Locked In Retirement Account.
Before continuing with the background information, it would help to get some terminology out of the way..
The commuted value of a pension is an actuarial calculation which states what the total value of your pension in the future is worth today. To give a very simple example, assume you received a pension of $1,200/year ($100/month) starting at age 65, and given your actuarial profile, you would live to the age of 85. Given that, the total payments you would receive would be:
But, that $24,000 is the value of the pension as you receive in the future; to be accurate, you have to discount that back to the present day. If we extend our example to assume that we have a discount rate of 5.25%, and we are currently 50 years old, this means that the first annual pension payment of $1,200 (i.e. when you turn 65) has to be discounted back 15 years at the discount rate of 5.25%, or . The next payment would have to be discounted 16 years, or . If we do this for all of our payments to age 85 (our assumed death age), then the present value of the pension is then:
And if we do the math on this, we find that our $1,200 annual pension at age 65 is worth $7,353.54 in today’s dollars.
The example above is very simple, and a more true calculation would discount each (monthly) payment by the discount rate. Also, the assumption that the pension would last for 20 years is based on a number of actuarial tables, etc. But at the end of the day, the commuted value is the present day value of all future pension payments.
The other item to discuss is the Locked In Retirement Account, or "LIRA" for short. A LIRA functions much like an RRSP, with the following key differences:
- Under normal circumstances, funds in the LIRA are locked in until either your retirement age, or some other specified age as specified by the province the LIRA is registered in. For my purposes, I am basing my calculations assuming the LIRA is locked in to age 65.
- Under normal circumstances, money added to a LIRA can come only from another LIRA, or registered pension. You cannot add money to a LIRA at a time of your choosing as you would with an RRSP.
- Depending on the circumstances, you may be able to transfer your LIRA to your pension plan with another employer in the future.
Put another way: when you open the LIRA, any and all money is inaccessible until the prescribed age of withdrawal, or if available to you, you transfer the funds to another registered pension plan. If the market goes south and your LIRA loses 90% in value, you cannot add money to bring it "back up". Similarly, if it grows in value over time, you cannot withdrawal that money until some time in the future.
For my own personal situation, after leaving my previous employer I elected to incorporate myself and become an independent consultant. This mean that Option 2 was not possible, as I would no longer be employed by a company with a pension plan to transfer the funds into. The other options would be Option 1, leave my money with OPTrust, and Option 3, transfer it to a LIRA.
The formula for OPTrust when calculating the defined benefit pension is:
Based on my years of service, and average salary, the pension I could have expected to receive at age 65 would be approximately $600/month, or $7,200/year. But, that is $7,200/year in 28 years!! The Bank of Canada has an inflation target of 2.00% annually. If we discount back the pension offered by my previous employer at the inflation target of 2.00%, that would equate to $426.67/month in today’s dollars. I’ll be honest: I think I can do much better than that.
That said, because the pension offered by OPTrust would be worth relatively little in the future, and because I did not have an employer to transfer my pension to, I went with Option 3. The second part of this series will outline the quantitative analysis I performed to come to this conclusion.