I spent Sunday helping out my brother in organizing his finances. He joined a major Canadian corporation a little over 11 months ago, and is approaching the point of vesting for his defined contribution pension plan. Within this context, vesting means that his employer will start matching any pension contributions he makes, subject to certain rules and maximums. This is a very common investment vehicle available to Canadians: many companies do not have Defined Benefit (DB) pension plans anymore, opting to provide Defined Contribution (DC) pensions instead. As an incentive for employees to save towards retirement, companies that offer DC plans often provide a “match”. A “match” is a provision wherein the employer will match any contributions an employee makes, subject to certain conditions. For example, one company I know of offers this match structure:
- Match 100% for the first 2% of contributions
- Match 50% for the next 2% of contributions
- Match 25% for the next 2% contributions
In the above, the “2% of contributions” means 2% of the employee’s salary. A more concrete example would be as follows: Assume an individual makes $40,000/year, and wishes to maximize her employer match. The numbers would add up like so:
Employee contribution %
Employee contribution $
Employer match %
Employer match $
As you can see above, the employee contributed $2,400 of their salary, but the employer contributed $1,400. This means that the employee received an instant 58% return for doing nothing! This is quite literally free money: your employer is giving you an instant top-up as incentive to save for your own retirement. Let’s take the example a little further: assume someone starts working at age 30, works for 35 years to age 65, and maximizes their contributions every year. Moreover, assume they get a 1% raise every year. If we plot this example over the duration of the person’s employment, the difference—while still a 58% gain—is even more pronounced.
By the end of 35 years, the employee would have contributed $103,000 on their own, if they had contributed 6% of their salary. But, thanks to the employer match, their effective contribution was $164,000! They have received an additional $61,000 all for doing nothing.
However, when an individual contributes to a plan such as the above, they don’t just save the money; they typically invest in mutual funds which are made available to them through the DC plan. We can modify the above graph to show the theoretical balance at retirement, assuming 2%, 4%, and 6% returns on the investments.
Again, there was a 58% gain when you compare the Employee only to the Employee and Employer Match:
Employee + Employer
The astonishing thing is that many people don’t take advantage of the employer match that is offered in their pension plans (here is an interesting read from the Financial Post). This means that there are people who are literally giving up free money. Often some people say that the reason they don’t do this is that they can’t afford to contribute money to their company sponsored pension plan, because that means that they will have less money paycheque to paycheque. To that, I have a couple of comments:
- If you are truly living paycheque to paycheque, then there are more systematic issues at hand that you need to look at; you really need to sit down and plan out a proper budget for yourself.
- You really can’t afford not to take advantage of a pension plan: if you don’t save now, then you will ultimately have to work longer later.
- Contributing to your pension plan is a tax-advantageous activity: meaning that if you wish to contribute $500 to your DC pension plan, your effective contribution is lower because your taxes will be lower; I will be writing about this in a future blog post.
So there really is no reason not to contribute. Imagine this: you are walking home and there is a fork in the road to go around a building. Both roads from the fork lead you to the same place at the opposite end of the building. From your vantage point, you can see a $20.00 bill lying on the ground up ahead on the road to the right, and on the road to the left, you can’t see any money lying around. Would you take the fork to the left? Of course not, you would be foolishly ignoring money that was just lying around. Your pension is the same: don’t take the road of no contributions, but take full advantage of the free money your employer is willing to give you.
Onwards and upwards!
This is part 3 of a 3 part series I have entitled "The Great Pension Experiment", which details my analysis on what to do with a defined benefit pension plan payout. The first two parts may be found here: Part I, Part II.
It has been one year since I started off on The Great Pension Experiment. I feel that this is a useful experiment because it leverages real world results in a closed environment. Because the funds are in a LIRA, I am unable to add or withdrawal funds, so any losses must be recouped “internally” by better investments.
In Part II I made the claim that, based on the Assertive Couch Potato Portfolio, over a 25 year time horizon I would be able to grow the portfolio to a point where I would be able to generate over $600/month in passive income, assuming a 4.00% yield. It has been 12 months since that claim, so lets see how we’ve done after one year.
When the portfolio was first opened, I set it up with a blend of 25% fixed income, 25% Canadian Equities, and 50% of non-Canadian Equities:
Originally I had intended on re-balancing the portfolio semi-annually (i.e. every six months), and in retrospect, this was a stupid idea. Cash was building up in the portfolio slowly, but sitting there idle until I had a chance to re-balance. Due to the already high number of shares, any dividends and/or distributions from the holdings would be in excess of the current price of those shares. Because of this, I should have been using synthetic drips right from the start! Accordingly, in September 2016 I set up my brokerage to re-invest any dividends received directly into additional shares. This ensures that money is not sitting idle, and because the investments are via synthetic drip, I receive additional shares commission free.
That said, as of October 2016 (one year), the portfolio sits at:
For the year ending October 31, 2016, I received $1,485.24 in dividends/distributions ($123.77/month). The portfolio as a whole has grown from an initial investment of $64,723.32 in cash to $68,468.29, which represents a 5.648% total return. This is actually pretty impressive, since the first half of the fiscal year (From November 2015-April 2016), the portfolio was in negative territory:
|Period Ending||Open NAV||Close NAV||Return %||TTM Return %|
I had bought into the portfolio at a peak in 2015, and the market had a clawback shortly after. As a result, the portfolio lost money for the first six months. I did take the opportunity during that period to top off the VXC shares whilst I had some excess cash from distributions, which in retrospect was a wise choice. Buying when the market is in a downturn helps to dollar cost average down, ultimately increasing future returns.
The portfolio is more or less at the target weighting if you round to the nearest whole number, and because of this I see no need to buy or sell additional shares at this time. Hypothetically, if the portfolio were to keep this pace for another 24 years, even at a 5.000% return we would generate approximately $736/month in passive income. So based on simple extrapolation (i.e. assuming constant returns for the next 24 years), we are right on track.
That said, I am going to ignore the portfolio for another six months, and will revisit in May of 2017 to see if any rebalancing is required. Until then, the next update will not be until December 2017. Here’s hoping that the portfolio continues to provide excellent returns at that time.
Onwards and upwards!
This is part 2 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.
I am a big fan of Monte Carlo analysis (MCA). In a nutshell, when performing an MCA we run a test a fixed number of times, using a controlled set of inputs, and observe the results.
I had mentioned on my previous entry that I felt I could do better than the $600 per month defined benefit pension that OPTrust was offering after I left the company. But, how would I quantify this?
I wanted my LIRA to be as simple as possible, to run virtually effortless. Because of this, I elected to use one of the Couch Potato model portfolios, specifically the one using ETFs. Within these options, given my 25+ year time horizon, I elected to use the Assertive Portfolio, which has the following composition:
- 25% of the Vanguard Canadian Aggregate Bond Fund ETF, VAB
- 25% of the Vanguard FTSE Canada All Cap Index ETF, VCN
- 50% of the Vanguard FTSE All-World ex Canada ETF, VXC
The weighted average expense ratio of this portfolio is 0.18% as of November 2016, and the returns are pretty impressive:
- 1-year return: 7.20%
- 3-year return: 12.61%
- 5-year return: 8.91%
- 10-year return: 6.24%
- 20-year return: 7.10%
- Lowest 1-year return (2008-03 to 2009-02): -24.95% (2008 financial crisis)
To perform my analysis, I elected to take the lump sum from OPTrust, and run an MCA on it to see what the projected monthly income would be in 25 years, if I had used the Assertive Portfolio. To do this, I ran 100,000 iterations on 25 years of growth in the portfolio, using randomized returns. Here is an example of one set of returns:
|Year||Start Value||% Gain||End Value||Implied Annual Income||Implied Monthly Income|
In the above, the % gain is a random gain for the portfolio based on an average return of 8.29%, and a standard deviation of 7.96%. The implied annual income assumes I could take the ending value of the portfolio, and buy an annuity or other similar (set of) instrument(s) to generate 4% of annual income. I believe 4% annual income, if you are not concerned with growth, is incredibly doable in the market.
But wait, where did that 8.29% average return, and 7.96% standard deviation come from? And what do they mean?
If you take 15 years of returns for the couch potato model portfolio, and do some statistical analysis on that data, you will end up with an average daily return of 0.032%, which equates to an average annual return of 8.287%. Moreover, those same daily returns have a standard deviation of 0.503%, which is 7.959% annualized. (For annualizing, I assume there are 250 active trading days in the year: 52 weeks @ 5 days/week, less 10 days for various holidays). Now, because the model portfolio asks for VAB, VCN, and VXC, and those ETFs are relatively new, I used iShares Core S&P/TSX Capped Composite Index ETF (XIC), iShares Canadian Universe Bond Index ETF (XBB), iShares MSCI World Index ETF (XWD), and iShares Core S&P 500 Index ETF (CAD- Hedged) (XSP) as proxies:
- For the period of October 29, 2009 to December 31, 2015, I used a blend of 25% XIC, 25% XBB, and 50% XWD.
- For the period of April 15, 2002 to October 28, 2009, I used a blend of 25% XIC, 25% XBB, and 50% XSP.
The ETFs listed are iShares ETFs. The XWD is the equivalent to VXC, but prior to October 29, 2009, there were no ETFs I could find that were all-world excluding Canada ETFs. Moreover, the period I chose covers the tail end of the dot-com bubble, as well as the massive 2008 financial crisis. Doing this provides more real world examples. In fact, looking at the above table you can see that in this iteration, in years 18 and 20 the sample has massive declines of -14% and -8% respectively! I feel this is an accurate representation of what could happen.
The average and standard deviation play into each iteration of 25 years. In the table above, the “% Gain” column will be, on average, 8.29%, and vary with the standard deviation of 7.96%.
Now, if we pull this all together:
- Create the table above 100,000 times
- Take the final 25 year implied monthly income from each iteration
- Plot a histogram
We get the following:
The above histogram shows that we have a 16% probability of having total monthly income less than or equal to $786. Put another way: we have an 84% probability of having implied monthly income greater than $786. If we take this a little further, we have an approximately 7% probability of making at most $600, or a 93% probability of making at least $600.00. But wait, OPTrust’s defined benefit income would be $600/month. I have only a 7% chance of not beating OPTrust’s defined benefit pension! Screw you OPTrust, I’ll take my chances.
So, based on my Monte Carlo analysis, using 13 years of historical returns on a portfolio of 25% Canadian Equities, 50% non-Canadian Equities, and 25% Canadian Fixed Income, I took the plunge to invest all of my money from OPTrust into my LIRA, using the couch potato portfolio. That was almost a year ago. In my next post, I’ll speak to the first year of actual results.
Onward and upward!
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.