When your teacher friends get together and start talking about when they can retire, citing the “85 factor”, does it make you feel like you’re at a disadvantage? Are you perhaps a tiny bit bitter?
Maybe you have pension plan envy. A employer pension plan can seem like the holy grail of financial security and many people wished they had one. Although there are lots of great things about being in a pension plan, it’s maybe not quite as wonderful as you might think. More importantly, you don’t need a pension plan to retire well.
Who's got a pension?
In Canada about 38% of workers have a pension plan with their employer. Not all of those folks have the “gold standard” though; in fact only about 25% of workers have a defined benefit pension (DB) plan, which is the one most people think of when they hear “pension”.* This kind of pension plan is the one that pays you a guaranteed amount every month from the time you retire until the time you die. These plans are most common in fields like teaching, healthcare and government work but can be found in other sectors too.
The 75% of paid workers in Canada who don’t have a DB pension plan might feel aggrieved. No doubt, defined benefit pension plans have their benefits: the employer contributes to it, the monthly retirement payment is guaranteed and usually rises with inflation, and there’s no worry about managing the investments in the plan – it’s taken care of for you. But it’s not all roses and butterflies. There are some less-than-great qualities too.
1. You are required to make contributions no matter what (almost). If you are doing a big renovation on your house, your car engine imploded (not sure if that's possible?), or the payment on your variable rate mortgage has shot up making your cash flow tight, you still have to contribute – the money comes right off your paycheck. The level of contributions can be quite high too – Ontario teachers contribute 10.4% of their income, and that’s 10.4% in good times and bad.
2. People who are in these types of plans sometimes feel tied to their employers and their job. The longer they stay, the bigger the pension. Although it’s not necessarily the right way to look at it, sometimes it keeps people doing work they are no longer enjoying. Also, for a pension plan to pay a good amount of income in retirement, you have to in the plan for a long time, often 20 or 25 years. That's a long time in one job or with the same employer.
3. You have little flexibility with these plans. In addition to having no say over how much you put in, when you retire you have no say in how much you receive. At times, the payment might be more than you need and you end up paying more tax than you really need to. Other times, you want more money for a special expense but it’s not an option to take more.
Benefits of RRSPs over pensions
If you have a defined benefit pension plan, you should be happy about that. But if you don’t, try to curb your envy. You’ve got options for creating your own retirement income. Using an RRSP to save and create a stream of payments in retirement has its benefits. If you were to put away 10.4% of your income for 25 years, you too can build a decent retirement fund.
RRSPs have some of the same qualities as pension plans: contributions you make are tax deductible and, once converted to a RRIF in retirement, pay you an annual income. There are significant differences, of course: your employer may or may not contribute to your RRSP, the income you receive in retirement isn’t guaranteed, and you need to find someone who can manage the investments for you if you aren’t confident about doing it yourself.
RRSPs have some advantages though.
1. You can withdraw more than the minimum required from your RRSP every year, giving you more control over your income.
2. You can defer taking withdrawals until you’re 71, giving you more control over your income, which impacts your Old Age Security benefits and how much income tax you have to pay.
3. Pension payments usually rise in-line with inflation (sometimes less than inflation). Your RRSP, if invested, can grow faster than inflation especially if you’re invested in the stock market, which historically has returned more than inflation over the long-run. This allows you to take payments from your RRSP that grow faster than inflation.
4. When you die, your spouse might receive a portion of your pension payments – how much they get depends on the plan. It’s often about 60%-65% of the payments you were getting. When you die with a balance left in your RRSP, the entire amount goes to your spouse. And when your spouse dies, it goes to your heirs (minus taxes owning on the death of the second spouse).
Create your own pension plan
There are three things you can do to mimic some of the benefits of a pension plan.
1. Set up automated transfers from your chequing account to your RRSP on payday to create the forced savings element of a pension. You will get used to living on less and be less tempted to skip a contribution.
2. Contribute a percentage of your annual income. This means you’ll be contributing more as your income rises, which is what happens when you’re in a pension plan.
3. Invest the savings in the stock market. You need to be earning a good return on this money – a savings account won’t cut it.
Some employers offer a defined contribution plan or a group RRSP. Often the employer will contribute alongside you - if this is the case, jump all over this. You'll be even closer to feeling like you're the 25%.
Stop the envy
A common, sage piece of advice is to focus on the positive. There’s no point wishing you had a pension plan – just get saving! Take advantage of the plusses offered by RRSPs. You too can retire well!
*The other type of pension plan is a defined contribution (DC) plan, which does not provide a guaranteed income. These plans are very much like RRSPs except often your employer contributes and they hire a company to manage it for you. Payments from a DC plan are calculated based on the value of the account so will change year-to-year - for better or for worse.