Regular reader, commenter, and personal finance enthusiast, DAvid, has shared with us some of his thoughts on how to determine the true “value” of a defined benefit pension.
As an avid follower of Frugal Trader’s Million Dollar Journey, and subsequent to some discussion on the topic, I began to wonder about where a Defined Benefit Pension (DBP) puts me on my personal MDJ.
The following is based on the Defined Benefit Pension Plan in which I am enrolled; most Canadian based government plans should be similar.
A recent article in Moneysense, indicated that about 50% of younger workers have a pension plan. An astounding 60% of Canadians over 55 have a pension plan, worth, on average $260,000. In most DBP, only member contributions and interest are reported to the member; the employer contributions are not reported in the annual valuation.
Many of these DBP, will pay up to 70% of the member’s then current income (or best 5 years income), and usually include a joint benefit to the spouse. This makes the actual value of the DBP much greater than the annual report would suggest. Since none of us know with certainty our lifespan, we all wish to ensure a large enough nest egg to provide us a comfortable living until death. We may also wish to leave an estate for children or other purposes. However, if the first goal of accumulating wealth is to provide for retirement income, how does a DBP stack up against a retirement portfolio?
For this example, the Canadian family average income of $75,000 per annum is used as a benchmark. The contributor(s) are 40 years of age, thus at a fairly stable point in their career. The following assumptions are made:
- Inflation = 2.5%
- Cost-of-living pay increases = 2.5%
- Annuity investment return in retirement = 6%
- Plan member contributes for 35 working years
Based on the amounts one would receive from a defined benefit pension, one would have to purchase an annuty in the following amounts to ensure income equivalent to a DBP until age 90:
|Age||Salary||Pension||Annuity Cost to Age 90 (6%)|
Those who are fortunate to have a DBP are well on their way to their first million already, even if they choose not to maximize their pensionable time.
While you don’t actually accumulate this wealth, and do not have a large estate upon death, the member and spouse will have a comfortable, often indexed, pension as long as either lives. It is also realized individuals may not live to 90, but DBP are a form of insurance, whereby it is expected that some will have a longer claim period than others. If, on the other hand, one needs to build wealth individually for retirement, how long should you plan to ensure income? Current age expectancies for a 40 year old in good health, with a good family health history is 77 – 78 years, but many live longer! Is a 90 year lifespan sufficient in planning a financial future?
This certainty of future income allows one to make many other considerations as to the use of the savings accumulated through regular RRSP contributions, the creation of a non-registrered portfolio, or other investments. This could fund early retirement, educational opportunities, sabbaticals, or other options for an enjoyable lifestyle.
If you are a member of a defined benefit pension, what will you do with your second million?