Demystifying Pensions – Podcast on Explore FI Canada
Demystifying Pensions – Podcast on Explore FI Canada
If pensions have you confused, this episode’s for you!
I was interviewed on a fun podcast with Chrissy and Money Mechanic from Explore FI Canada answering questions from a listener named Kate about her pension.
Kate asked her questions in an entertaining way that showed her frustration with not understanding her options.
We discuss DC and DB pensions, commuting, LIRAs, and more. Simple, clear info to help demystify the whats, hows, whys behind pensions in Canada.
Here is the link:
Demystifying Pensions – Podcast on Explore FI Canada
Ed
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That is a great article. Thank you. I teach a course that I call “Financial Wellness” to grade 11s and 12s at my school. I’ll be sure to share that one with them. We have talked about the CCB, but I didn’t bring any of that up!
My boys are 10 and 12 so we have 5 and 7 years to collect CCB. We have 11 years until we reach 55 and 52 and plan on retiring. All of that tells me that I should be using my RRSPs.
I really appreciate the time you have given to my questions. This has been so insightful and I have learned a ton and am changing my financial plan because of it. Thanks so much
Hi Sean,
Your main issue left is whether to save RRSP room.
How many years until you would commute your pensions?
If you would both commute your pensions, then the decision of whether or not to save RRSP room applies to both of you.
To figure it out, compare your marginal tax rate now vs the year you commute and estimate growth on your tax refund, assuming you would invest it.
For example, your marginal tax bracket today is 30.5%, but higher because of the CCB. I have an article about this (https://edrempel.com/new-tax-on-parents-and-8-ways-you-can-benefit/ ), so probably add 5.7% to your marginal tax bracket to make it 36.2%.
Let’s say you contribute $10,000 to RRSP now and get tax refund plus higher CCB of 36.2%, or $36,200. Let’s say you invest and average 10%. After 3 years, you are up to $48,200. If you commute your pensions, you save 48% tax, which would be $4,800 for every $10,000 of room. Would your kids be too old for CCB then?
In other words, if my scenario with your life is correct, it would be worthwhile contributing to your RRSP now, unless you plan to commute your pensions within 3 years.
Ed
I am wrong. It looks like Alberta allows you to unlock your LIRA at 50
That is correct, my wife would not be able to collect pension for 3 years. My understanding is that she can’t withdraw from her LIRA/LIF until 55 as well though (maybe I’m wrong about that). So, just the cash portion that would be invest in the RRSP would be accessible for those 3 years. We will have other investments (TFSA, RRSP and Non-Reg) that will be able to cover us for those 3 years. We are in the 30.5% tax bracket and I doubt we will ever be pushed into the next bracket (We got a 1.25% raise this year – first raise in 9 years) so it should benefit us to wait until we commute. If only I knew exactly what room I needed when that happens. I’d like to contribute some now too to lower our taxable income to receive more CCB benefits for our 2 children. But commuting would put her in the 48% tax bracket….thinking about it now though, maybe I use my RRSP room right now as my tax bracket will be unaffected her her commuting. So much to think about 🙂 Thanks so much for the conversation!
Hi Sean,
I forgot to mention in my last response, if your wife wants to retire at age 52, she probably cannot collect her pension yet. You could that year, since you will be 55, but that means half your income for 3 years. Commuting allows you to access both pensions and retire earlier.
Keeping RRSP room to use when you commute your pension may or may not be most beneficial to you. If you contribute this year, what is your marginal tax bracket vs. the year you commute. Probably the highest bracket of 48% in Alberta. (Albertans are lucky it’s not over 50% like most of Canada.)
Which is more:
1. You contribute this year and invest your refund until the year you commute.
2. You save your RRSP room to save tax in the year you commute.
Ed
Wow, thanks so much for that reply! The main reason I asked was that we maxed out our TFSAs and we still have a bit of RRSP room. I started to invest in our Non-Registered accounts so we could have more room in our RRSPs in case we did decide to commute 1 or both of the pensions. Since I am a 100% equity investor, I will continue using our Non-Reg account to save on taxes when we commute.
Thanks again for all you do. I am loving the YouTube Channel too!
Hi Sean,
The short answer is that we still find it beneficial to commute your pension in most cases, depending on how you invest.
We have software that calculates your benefit comparing commmuting today & paying tax on the non-transferable amount with taking the pension income over time. It includes your specific marginal tax brackets. It gives us a breakeven long-term average return that your investments would have to make to provide you with the same after-tax income through your retirement.
The commuted value is the amount a pension will transfer to your RRSP tax-free if you want to take it out and invest it yourself. Usually not all is transferable to your RRSP. The excess amount is paid to you in cash and taxed.
With a pension, you don’t own any of the money. Your pension owes you a retirement income for life based on the formula in the pension. When interest rates are low, the pension uses a low interest rate to calculate your commuted value, so the value needs to be higher to make up for the low interest and provide your lifetime pension income.
Up until last year, commuted values were quite inflated with interest rates so low. The amount you can transfer to your RRSP was historically roughly the value of the pension, but until last year, that was only 1/2 of the commuted value. For example, in normal times, a pension may be worth $500,000 that you can transfer to your RRSP. Last year, we would get a value about $1 million to commute it, of which $500,000 can be transfered to RRSP and $500,000 was taxable. Big tax bill, but an inflated value that made commuting much more worthwhile.
Last year, we had a few clients considering commuting their pensions. They typically needed only about a 4%/year long-term return on their investments to provide the same income as the pension. Today, that breakeven rate of return is about 5.5%.
Given that stock markets long-term have average 10-11%/year and that the worst 25-year calendar return of teh S&P500 in the modern stock market is 8%/year, those are quite low breakeven returns.
It’s easy to get a higher long-term return if you invest completely in the stock market (equity investments). However, if you are a conservative balanced investor with 50% of your investments in bonds or fixed income, then 5.5% is roughly your long-term expected return.
In short, equity investors get a major benefit by commuting and can expect a sigificantly higher retirement incomme than their pension, but conservative balanced investors roughly breakeven.
There are other major factors with commuting other than the amount of income, such as:
– The pension is guaranteed, which can give you some piece of mind.
– Having the investments yourself gives you control. You can choose larger amounts some years and smaller other years, and could take out lump sums if you want. A pension is a fixed income, while investments give you control.
– The pension survivor benefit is usually 60% to 100% if your spouse outlives you and then nothing for your kids or beneficiaries. Having the investments yourself by commuting means your spouse, kids & other beneficiaries get all of what is left when you are gone. A 60% survivor benefit for your spouse might mean a big drop in their retirement income. Leaving an estate for your kids is important to many people.
It’s important to get advice on commuting your pension. There are major factors involved and it’s not reversible. If you commute, then you need to be confident in your investments to provide the return, even though breakeven returns are relatively low.
Ed
I enjoyed listening to this, thanks for all you do. Do you think, as interest rates rise, it’s still worth commuting a DB pension? My wife and I are both teachers in Alberta and the commuted value has been reduced drastically (it’s worth 70% of the value even after working an extra year). It seems like the pension payouts are looking better, but we plan on retiring when I’m 55 and my wife is 52. Does that 3 year gap where my wife is not able to collect her pension still make the commuted value more valuable? Any insight is appreciated. Thanks
Hi Linda,
Thanks for taking the time to comment.
Ed
Ed Thanks, I enjoy the information you privide! Linda
Hi Linda,
You can transfer a LIRA(“locked-in RRSP”) into a normal RRSP from age 55. This process is called “unlocking”. You should do it when you want to start withdrawing. Unlocking means 50% goes to a normal RRSP (or RRIF) and 50% goes to an LRIF (locked-in RRIF) from which you are required to take a minimum withdrawal each year.
Withdrawing is based on your Financial Plan and when you need the money. In general, it usually makes sense to leave your investments grow tax-deferred in a LIRA or RRSP while you are working and then start withdrawing when you retire. It takes planning to know when you have enough to retire with the lifestyle you want.
There are sometimes other reasons to withdraw from your RRSP early. For example:
– You may be able to withdraw some in a low tax bracket that you expect will be in a signficantly higher tax bracket later.
– You may be able to get higher GIS income with the 8-Year GIS Strategy by taking RRSP withdrawals before you retire to invest in a more tax-preferred way. This is a complex strategy with many creative methods that RRSP withdrawals might help with.
– If you have a year or 2 with unusually low income, you may be able to maintain your lifestyle and withdraw in a low tax bracket from your RRSP.
It is nice to have a massive RRSP, but if it is too large, it can be difficult to withdraw while avoiding the higher tax brackets. This can still be good for you if you were in an even higher tax bracket when you contributed. RRSPs are generally favourable for you if you can contribute while in a high tax bracket and then withdraw in a lower tax bracket. If you can’t, then TFSAs may be better for you than RRSP.
I hope that is helpful, Linda.
Ed
Hi,
I understand that a portion of a federal locked in RRSP (LIRA-is what I call it) can be transferred into a RRSP when someone reaches age 56. I know having RRSP’s are advantage for deferring taxes. Is there any times when someone would want to free up registered money. I.e with drawl from RRSP and take the tax hit instead of leaving it in an RRSP? Are there disadvantages to having alot of money registered?
Thanks!
Hey Ed! I really enjoyed this episode and I had a question regarding commuting. I am 35 and starting a family so I will have service I can buy back when taking time off for parental leave. Does buying back this service time impact the value if I commute my pension? I assume it would mean I receive I higher commuted amount but couldn’t find confirmation of this anywhere. Thanks so much!
Hi Kevin,
Yes, there is new pension legislation. Here it is: https://pensionsolutionscanada.com/important-regulatory-updates-impacting-defined-benefit-pensions-in-2020/ .
This should apply to all defined benefit pensions in Canada, unless they have a specific exemption to using the very low current rates.
Most pension today are using super-low discount rates of 1.4% for 10 years and 2.4% after that. So you understand how this works, if your pension is supposed to pay you $30,000/year rising by inflation starting 20 years from now, you need about $850,000 today to make those pension payments with investment return rates of 1.4% and 2.4%.
I thought at first these super-low rates related to the bond portion of their portfolio only, but it relates to the full value of the pension.
Commuted values will be lower, and probably quite a lot lower.
We have been trying to figure out how big a change this will have. I believe the pensions will choose a more normal discount rate about 5%, or at leat 4%, which could mean a much smaller commuted value effective December 1.
If you quit your job and request your pension, they use the date you request it, not the date the pension is paid out, so there is still a little time.
We have several clients that were planning to retire or quit their job in the next year or 2 anyway, where we are helping them figure out whether or not this legislation change makes it worthwhile to quit or retire now.
Ed
Another good episode.
There has been some discussion on the FI forums about some legislative changes coming this year to Commuted Value calculations…specifically in some of the actuarial assumptions that are used. The word is that after these changes, commuted values for DB pensions will be lower. Are you aware of this? Is this just a provincial change or will it affect federal pension plans too? I have seen some articles discussing the changes but haven’t found the original source or details of which pension plans will be affected.