Pension buy back dilemma - help needed!

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undiscovered
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Pension buy back dilemma - help needed!

Post by undiscovered »

Hi everyone,

It's been a while since I've posted on the forum. I’m getting back into the swing of investing and now need your insight.

Here's my situation:

I'm currently 33. I recently moved provinces and changed jobs. I have a wife and 2 children. I had 8 years of pensionable service with my former employer. It was a DB pension plan. I was NOT able to transfer my pension to the new employer based on reciprocal agreement conflicts. Thus, I decided to have the 8 years of service paid out (approx. 140k). The funds are now kept in a LIRA. I also have 120k in RSP/TFSA combined.

My new employer said I could purchase 8 years of service but would have to use RRSP/CASH. 8 years of service would cost me 120k. 80k from RSP and 40k from TFSA. By utilizing my RRSP and TFSA I would be liquidating all of my retirement savings. I would still have my LIRA (140k value) and would invest it as though it was my standard RRSP. The caveat – I would not be able to touch the LIRA that until I'm 55 years old when minimum withdrawals would begin.

The dilemma:

Option 1 - Keep the 120k that I currently have in my RRSP/TFSA and invest it myself and let it grow at 4-5% conservatively until from age 33- 55.
At age 55 I would have approx 250k. If I retired at 55 I could draw 4% each year - $10,000. I would not touch the principle amount.
If I retired at 55 with my current employer I would have 22 years of service which would be $3000/month (+$10,000/year from my RSP/LIRA if needed).

Option 2 - Pay the pension company 120k now for the 8 years of service and retire at 55 years with a monthly income of $4800/month


Obviously there are pros and cons to each scenario:

1) If I die early I just gave the pension company 120k - they would then have to transfer that money to my wife into a LIRA - which would not be accessible until age 55. She would also incur taxes on the transfer. She could receive the survivor benefit and a monthly pension but it would be a lower amount.

2) If I enjoyed my job and decided to work until 60 I would have a pension of 27 years v.s 22 years. Not only would I have a larger pension, but if I kept the 120k and invested it myself I could be better off ahead because I would only need to use it when needed.

3) Investing the 120k myself would not be indexed to inflation.

4) I will continue to save $500/month into my RSP from now until age 65. With a conservative growth of 5%.

5) My wife will work part-time and likely have a small pension but i'm not including that into the equation for simplicity sake.

I'm not a major risk taker, however, my gut says keep the money and invest it myself. Primarily because if I died young, or died early in my retirement years, I would feel better that my wife (and kids) would have funds available to them. There is something about giving the pension fund this large sum of money that doesn't sit well. Also, while the pension route seems stress free, I feel I could conservatively invest the money and still break even.

What would you do?
I'm open to suggestions!
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Re: Pension buy back dilemma - help needed!

Post by OnlyMyOpinion »

Personally I would keep my $80k RRSP, $120k LIRA, and $40k TSFA. I'd let my new pension plan start at scratch. I assume the new one is also a DB? Is it contributory?
I'm not sure if this makes the most financial sense in terms of "if I live till 55 which choice will give me the biggest pension." But I like the idea of having several sources of retirement income that I may tap at different times during retirement, as well as the flexibility that my RRSP/TSFA provide.
This presupposes that I continue to contribute to, and properly invest my accounts. I suspect the TSFA may not have to remain earmarked for retirement depending how your savings go over the next 10-15 years. Similarly I may be able to back off of my RRSP contributions in the future (or only fund the spousal) as value builds up in my company pension.
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Re: Pension buy back dilemma - help needed!

Post by adrian2 »

For a DB pension, grab it with both hands (option #1).
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Re: Pension buy back dilemma - help needed!

Post by brucecohen »

Undiscovered, it's interesting that you focus more on the risk of dying early than the risk of living to a ripe old age. Unless you have health/lifestyle issues and/or family history of short lifespans due to chronic disease, the latter is more likely than the former. Also, you've only considered the LIRA your spouse would get if you die before retirement. What about if you die in retirement? Pension law guarantees your wife a lifetime survivor's benefit equal to at least 60% of your pension -- unless she waives that at the time you retire. (On average, if your wife is also 33 there is better than a 49% chance that at least one of you will live past 90.)

You did not explicitly say that your DB pension would be inflation-indexed, but you did imply this by noting that your personal investing would not. So I'll assume there's DB indexing. Nor did you indicate if you're a public employee. That's a very important factor because public sector plans are stronger and more reliable than private sector ones.

IIUC, you can pay $120,000 today for $1,800 of additional monthly pension starting at 55. So, what's the present value of the additional income stream? Let's assume:
-- $1,800 paid monthly indexed annually for inflation at 2%
-- Payout begins at 55 and runs to 90: 35 years
-- Discount rate = 5%. That's what you reckon you can earn if investing the money yourself

Capital required on the day of retirement would be $471,294. But that's 22 years away. So let's convert that to today's dollars by discounting it for 2% inflation. The current PV is $304,851. So you'd pay $120,000 for $304,851 of future pension. That might seem overly generous but reflects the legal requirement that a DB plan sponsor pay at least 50% of the cost of the pension paid out.* (Hence, adrian's advice to grab it with both hands.)

(* Just occurred to me that I used age 90, the common rule-of-thumb but your $120,000 quote reflects the average life expectancy table for your plan's membership which likely puts your best-before date in the mid-80s.)

NOTE: Calcs like this are highly sensitive to the assumptions. If the plan is not fully indexed, the PV will be lower. If the discount rate is 4%, the PV will be higher. If the pension starts at 65, the PV will be lower. etc, etc. If you want to post alternative assumptions I can re-run the calcs but appreciate that the buyback will at least match your money with employer's money, immunize you and your wife against market risk, immunize you and your wife against longevity risk and -- if the plan is indexed -- immunize you and your wife against inflation risk. (BTW, full indexing adds 20-25% to the cost of a DB pension.)

Also, you did not indicate if your DB plan is "final average." That's the most common and typically bases the pension on average earnings for either the best or last five consecutive years. If your plan is final average, do you expect to advance in your career or have you plateaued? If the former, a final average DB plan will pay more than you now expect, perhaps much more.

Finally, you did not indicate if you plan to stay with your employer long-term. DB plans work best for those with long service.
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Re: Pension buy back dilemma - help needed!

Post by ghariton »

The only thing I would add to Bruce's post concerns the consequences for your family of you dying early. The proper precaution is term insurance, not money in a RRSP or LIRA. At your age, you can buy term quite cheaply, planning on letting it expire at 55, or whatever retirement age. In fact you should do this whatever decision you reach on your pension, except in unusual circumstances

FWIW my wife had an opportunity to buy back ten years of service for her DB plan, She only bought back three. Second biggest financial mistake we made in retrospect.
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Re: Pension buy back dilemma - help needed!

Post by undiscovered »

Thank you everyone for your input. I truly appreciate your help. This is why I posted on the forum :)

Let me fill in more details.

Brucecohen:
The pension is through LAPP. It's a public pension plan in Alberta. It is a defined benefit plan. Cost-of-Living Adjustments (COLA) will increase at a rate of 60% of the change in the Alberta Consumer Price Index (so it is not completely indexed to inflation).

Just to re-clarify - I would be paying both my contribution and employer contribution for the 8 years of buyback service to reach 120k. Does that change anything? The new employer is not matching anything on the 120k, rather, they only match my contributions going forward in the plan.

One major concern I had which I did not bring forward in my original post was that 3 years ago the finance minster was wanting to change the pension plan rules so that the factor of 85 (age + service) would not longer be applicable. Rather, new employees entering the plan would have to work at least until age 60 to receive an unreduced pension (this is exactly what new gov't employees are offered if hired after 2012). So, I had move to Alberta 3 years ago, bought the 5 years of service, and this new rule was implemented, my "freedom 55" would have been altered as I would have had to work to 60 and work an extra 5 years regardless to receive the same monthly pension. Fortunately this change was never implemented but it always crosses my mind that "what if down the road pension rules change and I just bought these years of service for nothing". If I'm going to purchase all these years of service now I want to maximize my return on investment. Of course I can't predict the future, but if several pension plans are already moving this route (age 60 v.s age 55 to retire), who's to say LAPP won't follow?

I went a little overboard on dying young, however, anything can happen. To think i'd live until 90 seems unrealistic. If I make it until 80 with reasonable health i'd be happy. Working in the health care field I'm exposed to a variety of eye-opening situations. Just makes me wonder about the future. But as Ghariton said, term insurance makes the most sense to cover these uncertainties.

Ghariton - "FWIW my wife had an opportunity to buy back ten years of service for her DB plan, She only bought back three. Second biggest financial mistake we made in retrospect." So you are saying you wish you bought the entire 10 years?

Seems like the census is to buy back the years of service. I wasn't expecting to read this, but again, that is why I posted the question :)

Is there anything else I'm missing?
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Re: Pension buy back dilemma - help needed!

Post by ghariton »

undiscovered wrote:Ghariton - "FWIW my wife had an opportunity to buy back ten years of service for her DB plan, She only bought back three. Second biggest financial mistake we made in retrospect." So you are saying you wish you bought the entire 10 years?
Yes.

My wife was drawing on years of service with various school boards to add years of service to a federal DB pension. The implicit rate of return on the federal DB was 4 per cent real (i.e. 4% plus inflation). She could not have reached that with any investment as safe as the pension plan.

But that was in 1992. Things have probably changed since then. It's wise to "run the numbers" before making a decision. A back of the envelope estimate, such as Bruce sketched, will probably do, but using assumptions that fit your circumstances.

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Re: Pension buy back dilemma - help needed!

Post by brucecohen »

undiscovered wrote: The pension is through LAPP. It's a public pension plan in Alberta. It is a defined benefit plan. Cost-of-Living Adjustments (COLA) will increase at a rate of 60% of the change in the Alberta Consumer Price Index (so it is not completely indexed to inflation).
I just changed the inflation assumption to 1.2% to reflect. (60% of 2%). I also changed the runout age to 85. The 2009-11 StatCan table says that's the average life expectancy for a 33-year-old male. Note: ALE is the point at which half the members of your birth cohort are expected to be dead, so at any age you have a 50% chance of outliving the table. Also, the StatCan projections cover the whole population and are thus rather conservative. There's a direct correlation between socio-economic status and ALE. As a rule of thumb some/many planners with middle/upper middle-class clients add five years to the StatCan projection. With my 2 changes, your buyback PV at time of retirement falls to $390,537. Discounting that for 2% inflation between now and then gives us a PV today of $252,615. So doing the buyback amounts to purchasing a $252,000 asset for $120,000.
Just to re-clarify - I would be paying both my contribution and employer contribution for the 8 years of buyback service to reach 120k. Does that change anything? The new employer is not matching anything on the 120k, rather, they only match my contributions going forward in the plan.
You don't see the employer's match; it's built into the plan's funding and actuarial management. I mentioned it only to explain why the buyback PV is about twice the cost.
One major concern I had which I did not bring forward in my original post was that 3 years ago the finance minster was wanting to change the pension plan rules so that the factor of 85 (age + service) would not longer be applicable. Rather, new employees entering the plan would have to work at least until age 60 to receive an unreduced pension (this is exactly what new gov't employees are offered if hired after 2012)....
The key word there is "new." Pension laws prohibit DB sponsors like yours from reducing benefits already accrued. Thus, many plans -- both public and private -- are reducing or even eliminating coverage but only for new hires and, in some cases, for new accruals by current members. The simplest example of this is the indexation change made by the Ontario Teachers Pension Plan a few years ago. Credits accrued before then remain fully indexed while those accrued since then get partial indexing tied to plan solvency. So a teacher whose service spanned both period will get indexing at 100% for part of his pension and probably a lower COLA for the other part. A few private sector companies have frozen their DB plans and implemented DC on a going-forward basis. So a retiree would get two pensions; the full DB pension accrued before the change and whatever income stream the DC balance can fund.

Ghariton will no doubt point out that I've described pension law's protection against adverse change as it exists today and that the legislature is free to change the law. But such a change would require an expenditure of political capital and goodwill too great for all but the most ideological or financially-strapped governments. Interestingly, you're influenced by a past govt proposal that was not implemented but not by the fact that retirement expectations for many people who rely on RRSPs and DC plans were dashed by market crashes which occurred just before or just after they entered retirement. See "sequence of returns risk." This is much more apparent in the US where DC coverage is much greater than in Canada and has been used much longer.
If I make it until 80 with reasonable health i'd be happy.
The StatCan table I cited above indicates you have at least a 57% chance of living past 80 but makes no call on your state of health. The table indicates that if you were now 55, your target retirement age, your chance of living past 80 would be 60%. In effect, the longer you live, the longer you're likely to live -- but, as a statistical survivor, it will be increasingly hard to find someone your age to drink with. :wink:
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Re: Pension buy back dilemma - help needed!

Post by scomac »

adrian2 wrote:For a DB pension, grab it with both hands (option #1).
Yes, yes, yes! This is what we did for my wife a number of years ago by buying back past service. If the pension in question is run by/for one of the big public service providers then it is absolutely a no brainer. People hate giving up control, but in situations like this that is exactly what you should do.
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Re: Pension buy back dilemma - help needed!

Post by undiscovered »

Thanks everyone.

I have one other question about PSPA and how it affects my years of service purchased as well as RRSP contributions going forward.

I was told I have 100k in my PSPA.
I have 9k of unused RRSP room for this year.
I want to purchase 8 years of service for a total value of 115k.
By transferring 80k from my RRSP to the pension fund I will not incur taxes because it is tax sheltered, however, will my pspa now drop to 20k? Is that how this works?

And for the remaining 35k that I will pay using cash - will this amount be fully tax deductible when I file my 2016 taxes next year? Will it effect my PSPA at all?

Thanks again everyone!
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Re: Pension buy back dilemma - help needed!

Post by OnlyMyOpinion »

Undiscovered, Glad the knowledgeable folks stepped in to give you facts'-based opinion. My ignorance and bias (lack of a pension parachute) are obvious. Re/ tax implications of the cash portion purchase, is it possible/would it make sense to finance the entire purchase and keep your RRSP intact?
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Re: Pension buy back dilemma - help needed!

Post by brucecohen »

undiscovered wrote: By transferring 80k from my RRSP to the pension fund I will not incur taxes because it is tax sheltered, however, will my pspa now drop to 20k? Is that how this works?
Yes. You previously got RRSP room based on your DB pension coverage at that time. The buyback means your DB coverage for that period will now be better. So you have to give back RRSP room you were granted.
And for the remaining 35k that I will pay using cash - will this amount be fully tax deductible when I file my 2016 taxes next year?
Yes, providing it's equal to or less than your net taxable income.
Will it effect my PSPA at all?
I'm not sure. ISTM you will still have a 20k PSPA that will inhibit your ability to make RRSP contributions over the next few years. Again, there's a limit to the amount of tax sheltering you're entitled to. The retroactive DB credits will throw you over that limit no matter how you pay for it. The transfer from your RRSP will partly bring you back. AFAIK, the only way to wipe out the PSPA is to give up still more RRSP room.
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Re: Pension buy back dilemma - help needed!

Post by gsp_ »

Clueless and curious, why isn't the OP allowed to use his newly created LIRA to make the buyback?
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Re: Pension buy back dilemma - help needed!

Post by brucecohen »

gsp_ wrote:Clueless and curious, why isn't the OP allowed to use his newly created LIRA to make the buyback?
Probably because the LIRA is governed by the legislation that governs the plan from which the money came while the new DB plan is under different legislation.
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Re: Pension buy back dilemma - help needed!

Post by gsp_ »

Thanks Bruce. Does that mean any interprovincial move will automatically lead to such an issue?
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Re: Pension buy back dilemma - help needed!

Post by adrian2 »

gsp_ wrote:Does that mean any interprovincial move will automatically lead to such an issue?
Potentially yes, if the two plans are governed by provincial legislation.
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Re: Pension buy back dilemma - help needed!

Post by brucecohen »

adrian2 wrote:
gsp_ wrote:Does that mean any interprovincial move will automatically lead to such an issue?
Potentially yes, if the two plans are governed by provincial legislation.
Unfortunately, it's not always clear and, for some reason, I've never been able to keep it all straight.

The first two cases are easy:
1. A handful of industries are federally regulated.
2. If all of a company's employees work in the same province, there is only one piece of governing legislation to worry about.

More complicated is when a company has people in more than one province. Each employee's credits are governed by the law of the province in which he/she works. AFAIK, this does not mean your coverage under Ontario's law is frozen when you're transferred to BC. Rather, my understanding is that all accrued credits will fall under the legislation of the province of your final work location. Consider someone who was hired in Toronto, transferred to Halifax, then to Vancouver and then to Winnipeg where he left the company just before the plan's early retirement age. His DB credits would be transferrable to a LIRA governed by Manitoba's legislation. If he stays with the company past early retirement age, his DB pension would be governed by Manitoba's legislation. Again, I'm pretty sure that's right but am not totally certain.

Note: the applicable law is based on where you work, not where you live. Consider someone who lives in Hull, Quebec but works for a company in Ottawa. Her pension is governed by Ontario.

BTW the inter-provincial differences do not affect accrual rates, which are governed by the federal Income Tax Act, but rather nitpicky stuff such as access age for a LIRA, availability of unlocks and whether a spouse's pre-retirement death benefit is locked in. Big stuff like vesting and early retirement age are now uniform across the country though BC and Nfld set ERA as 55 while the others say 10 years before normal retirement age.

Here is a very handy pension law reference for those who feel compelled to give themselves a headache.
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Re: Pension buy back dilemma - help needed!

Post by gsp_ »

Thanks again Bruce. :thumbsup:
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