Following the market correction in 2008 we collectively have realized that pensions are not like diamonds – they don’t last forever. So how does this effect our retirement and what can we do about it? This series on pensions is going to explore the following: the basics of a pension, what’s wrong with pensions, some proposed solutions and what’s wrong with the cure.
So let’s look at the basics. Despite the common belief that the pension has been about the worker the reality was pensions came about as a means to get rid of older, more expensive workers and replace them with cheaper, more productive (in theory) younger workers. Pensions were for the benefit of the company. So they created the rules such that few workers would collect benefits and then would die shortly after getting benefits.
Today things are significantly more complex: we have vesting periods, defined benefit, benefit formulas, define contribution, minimum ages, group RRSP’s, LIRA, employer and employee contributions…and so on. No wonder people get frustrated with retirement planning, you can get a headache just look at your work pension plan. So here are some basic terms you need to know.
- Group RRSP – Technically this isn’t a pension plan at all. It can often be similar to a defined contribution plan, but pensions are regulated either federally or provincially while a group RRSP is not. The majority of pensions are provincially regulated making things even more difficult since the rules are not uniform across the country. The great thing about a group RRSP is since it isn’t a pension it is easier to transfer the money to another account if you are not happy with your investment options or if you want to use the money for an early retirement.
- Defined Contribution – In this plan the idea is the worker takes the risk of investment lose. The company often matches your contribution to a set amount and then provides you with investment options. Once you hit the minimum retirement age you can retire and use the money to live off. The catch here is there is no guarantee on the part of the employer on how much money you will get, yet on the plus side you can leave more easily with less risk of losing significant amounts of retirement income. If your investments do well, great. If they do poor, you have to keep working. On the plus side for the company there is significantly less risk with these plans since they don’t have to cover short falls from a bad year in the market. These pensions are much more common than defined benefit.
- Defined Benefit – Here the risk on investments goes to the company. Hence you are seeing fewer and fewer of these types of pensions since if the market does poorly the company has to make up the shortfall. On the plus side for the employee is you get a set benefit, determined by a formula, to replace a certain % of your pre-working income until you die. It’s easy, no thinking required. Yet there are downsides to defined benefit plans for an employee: 1) early retirement options are often very limited if they exist at all, 2) if the company goes bankrupt with a significant pension short fall your benefit can be reduced by a lot. Recently a common reduction has been about 33%.
- Vesting Period – Often if you work only for a short period of time the company doesn’t want you to walk away with the money it put in your pension. So if you leave prior to your vesting period you only get your money you put in the pension plan back, not the companies contribution. After the vesting period you get to keep both even if you leave. Two years is a common vesting period.
- Lock In Retirement Account (LIRA) or Locked In RRSP – Once you have vested money and you leave that company, you might not be allowed to transfer your pension money into a regular RRSP (it depends how much money there is and where the pension is setup) if not then you could transfer it to a locked in retirement account or Locked In RRSP. A LIRA is similar to an RRSP but often has some additional restrictions on it that carry over from your pension plan. Typically there is a minimum age that you have to be prior to taking the money out of the account.
- Canada Pension Plan (CPP) – People often like to complain about how few people are in a defined benefit pension plan and completely forget about the CPP. The CPP is about as close as you can get in this country to a near universal defined benefit pension plan, the problem is the payouts are tiny. Yet we need to give the CPP credit, they made adjustments a long time ago to correct for the problems facing most other pension plans today (Dave will write more on this tomorrow).
Obviously that is just a short overview of some of the terms out there, I could go on for a very long time. Yet that should be enough for a discussion for the rest of these series. If you have any ideas to add to this list or expand a definition please leave a comment.