Wednesday, 9 December 2015

Pension Basics

Pensions are kind of the golden ticket in retirement planning as they have such a huge impact on how much money will be coming in the door after you retire but not all types of pensions are created equal. Today I'm going to break down the two basic kinds of pensions that you would get through working, so this doesn't included government style pensions like CPP and OAS; we'll tackle those another day. 

Defined Benefit Pension Plans
DB plans are the real winners in the pension world and when most people think of a pension this is what their thinking of. A DB pension will pay you a guaranteed monthly pension after you retire that will be based on your years of service, salary and a bunch of far more complicated things. This means that you will get a pension cheque every month after you retire until you die (depending on the option you choose your spouse may even still receive your pension payment even after you die). This is the ultimate in safety and you would need to have a whole lot of money invested to come close to what your pension will likely pay out. 

Let's look at a quick example. Say you will receive a monthly pension of $2500/month, you retire and 60 and live to age 90. In this scenario you would get: $2500 x 12 months per year x 30 years = $900,000. 

Some defined benefit pensions also have indexing built into them. This means that they will increase over your retirement to either completely or partially keep up with inflation. As we're all aware, prices tend to go up over time (that's inflation) so $2500 today will not have the same buying power as $2500 in 20 years, that's what indexing tries to solve. A fully indexed, defined benefit pension plan is about the best and safest option you can have in retirement, problem is, not many jobs come with that benefit anymore because it's incredibly expensive for the employer. Keep in mind though, if you do get a DB pension with your job, make sure you weigh that if you're considering a job switch. You may get a higher salary somewhere else but that payment in retirement is significant. 

Defined Contribution Pension Plan
The other big option (and much more common these days) in pensions are DCPP's. These plans have both you and your employer contributing a portion of your salary into a retirement account that is similar to an RRSP, but with some extra restrictions. The big difference in the two plans is that where as the DB pension will pay you out a guaranteed amount until you die, the DCPP will provide you with money only until you run out. If you end up with $500,000 in your DCPP at retirement and you spend it all in the first 10 years of retirement, that money is goners so you need to make sure you plan your withdrawals accordingly. 

There are a couple other factors of DCPP's that many people do like. You can usually move your funds out of the plan at retirement (and sometimes before) so you can invest however you want (just as you would a personal RRSP). Another thing is that if you die that account will remain with your estate and pass on to whoever you have listed as beneficiary. With the exception of your spouse (if you chose that pension option), your DB pension will stop paying if you die, so if you don't live that long after you start your pension you wont receive that much money...of course, this is impossible to know. 

Now, when I say DCPP's go into an account similar to an RRSP this is true, but you do need to be aware of certain limitations. The accounts are usually called Locked-In RRSP's and they are exactly as they sound. Except for some exceptional situations, you cannot pull any money out of the account until you are retired and even then there are yearly minimums and maximums. The government does this so you don't do what I said in the example above and go out and spend the whole $500,000 (or whatever) in the first chunk of retirement...they force you to be at least somewhat responsible. 

Ok guys, those are the basics. Any type of pension is a great added benefit but you should be aware of what type of pension you have and what that means in retirement. Feel free to post any questions below. 

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