The Pension Series – Part I – The Basics

Posted by Tim Stobbs on November 30, 2009

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.

Book Review: Enough Bull

Posted by Tim Stobbs on November 19, 2009

David Trahair is back again.  The author of Smoke and Mirrors is back with a new book called Enough Bull that suggests we should all tell the stock market to go to hell and put all of our savings into GIC’s.

To be honest I can understand the feeling that drives this book.  By investing in just GIC’s you may not get a huge return, but you will be guaranteed your principle back which given the pounding we all took in 2008 sounds damn good once in a while.  Yet the book isn’t strictly about avoiding the stock market.  Instead he lays out a six point plan which includes:

1. Avoid Financial Disasters – Where he points out you should never borrow to invest, never buy something you don’t understand and  if it sounds too good to be true it likely is.
2. You Don’t Need the Stock Market or Mutual Funds – The pro-GIC part of the book.
3. Buy a Home and Pay Off the Mortgage – Actually it’s fairly sound advice for most people.
4. Reducing Expenses Don’t Have to Be Painful – Go after the big stuff of interest on your debt and income tax.
5. Forget RRSP’s Until the Mortgage is Paid Off - If you follow the GIC method this makes more sense.
6. Ask Yourself if You Really Need an Investment Adviser – Again if you use just GIC’s this is obvious.

The one paragraph I like the most in this book was one where he stated you don’t have to follow everything he lays out in the book.  He points out use what you want in the six point plan and ignore the rest.  Good thing he said that or I might be a bit pissed off.  I do get his point of view, but I don’t agree with all of it.

Here’s my six point plan which I just corrected the points in his that I don’t agree with:

1. Avoid Financial Disaster – Yes never buy something you don’t understand and if it sound too good run away, don’t walk.  Yet borrowing to invest does make sense at some points and for some people.  I would agree that you should likely limit your exposure to perhaps 10 to 20% of your portfolio depending on your own comfort level.
2. You Need Much Less Stocks Than You Think in Retirement – People often grossly overestimate their ability to recover from a down turn in the market once you are retired.  Recall you will likely have no other income source so it pays to be way more conservative with it.  I typically would suggest that you set up your fixed portion of your portfolio to cover all of your basic expenses so you could have a 70 to 85% in fixed income with the balance in stocks to provide some inflation coverage.
3. Buy a Home and Pay off the Mortgage – if it makes sense in your local market.  If you don’t plan to retire there, then consider just saving up cash to buy a home elsewhere.
4. Reducing Expenses Don’t Have to Be Painful – Yes hit up the big things first: interest on your debt and taxes.  Then cut back on areas you don’t care about (power bill, water usage) to boost spending on those things you love.  Also consider free or low cost alternatives.  The idea isn’t to cheap, but rather frugal.
5. Don’t Panic Over Maxing Out Your RRSP’s – You don’t have to do this early in your career.  Focusing on student debt and credit cards makes a hell of a lot more sense.  When you income rises up to a higher tax level then start using the RRSP’s to cut back the government’s hand in your pocket.
6. Use an Investment Adviser if You Want To – You don’t have to use one for GIC’s or if you are using some index ETF’s.  If you do use one make sure not to give them everything, that way you will limit the damage if they mess up.

This book was useful for me to read for one little tiny piece of information on CPP.  If your spouse dies you get their CPP pension, I’ve always know that.   I didn’t realize that you can only get up the maximum pension amount for one person.  So if both of you are getting the maximum pension already and one of you dies then you lose all of the second pension.

So overall it was a short read and I learned something new.  So it is worth reading the book from your library.  You may not agree with all of it, but it does make you think.

Book Review: The Number

Posted by Tim Stobbs on August 20, 2009

I picked up The Number by Lee Eisenberg and was pleasantly surprised by the book.  It’s a interesting read with a liberal amount of humor so it makes for a quick read.

Lee starts off wondering about his own number and how much he needs for the rest of his life.  He then points out the difficulties of actually getting to the number since there are so many factors to consider like:

1. Living in a culture where debt is so common getting your finances in order feel like climbing a mountain.
2. People being generally utter confused on how money works and have no motivation to learn.
3. The old retirement supports like a defined pension or generous government benefits are slipping away for most people.
4. Living with the uncertainty of doubt around future benefits like your corporate pension plan going bankrupt or an angry stock market god smashing your savings to bits (the book was written in 2006, so I don’t think he was predicting 2008).

Then through conversations with various experts Lee slowly brings us to face the fact the Number is a sneaky beast that changes colours and escapes the second you think you are close to getting it.

Yet perhaps the most useful things Lee brings people around to understanding is your financial planner now a days needs more than a good model to get the Number, he needs to also be a therapist to extract out of your brain your real desires and needs and use that information to build up your number.

Since let’s face it.  If you don’t know what you want to do in your retirement calculating how much you need for it is a useless exercise.  You will get a Number, but it won’t be useful to plan anything on.  Having a winter home in the US and living in BC is a completely different number than living in a small town in Ontario for retirement.  Also are you planning on some work, what are your hobbies, did you want to be near your grandkids, what are you going to do all day?

So overall I enjoyed this book alot.  It’s honest enough to say the Number depends on various factors and understanding it all is confusing.  Yet in the end, find what works for you and plan for that.