A government based defined benefit pension is considered the gold standard of retirement benefits. The requirement is that you need to work for the government for 25-30 years, contribute a small portion of your salary towards the pension and in return, you get 60-70% of your working income monthly (some pensions are even indexed to inflation) during retirement. It really is a great deal for employees willing to stick it out with the same employer for their careers.
The Risk of a Defined Benefit Pension
While defined benefit pensions are a great deal for employees, it is an extremely expensive benefit for employers to offer. With these pension plans, the risk sits with the employer whereas with a defined contribution plan, the risk is reverted to the employee. However, that does not mean that plan members do not face risk. Perhaps the greatest risk that a defined benefit plan member can face is a large unfunded pension liability. While pension bankruptcy may not be that likely with a Canadian government based pension, changes to the plan to make it sustainable can significantly impact retirement plans.
In fact, there were recent changes to the Newfoundland & Labrador pension plan because of the unfunded pension liability that has affected thousands of employees, yours truly included. While I’m not vested into the plan yet and do not plan to be working for another 25 years, it still does impact my future plans. The changes include an increased contribution requirement from employees, increased working requirement to qualify for retirement benefits, and changes to the deferred pension status.
How to Reduce the Risk
For new government employees just starting out with a long career ahead of them, there is a risk of further pension changes. While many young employees who are vested in a defined benefit pension believe that the pension will take care of them, my thoughts are that risk should be reduced by supplementing the plan. Future defined benefit plan changes cannot be controlled, but saving and creating your own pension for retirement can be controlled.
Once you’ve made a plan to squirrel away some cash flow, the next question is where to put the cash. For people with a defined benefit pension, I would suggest to put the money in a TFSA. Why not an RRSP? The reason is that pension payments during retirement are taxable and RRSP withdrawals would add to the income tax payable. The additional income could also impact seniors benefits. TFSA withdrawals, on the other hand, are not taxable, and do not affect seniors benefits.
If starting this year, maxing out your TFSA and passively investing the proceeds for the long term would result in about $218,000 in 25 years (assuming TFSA max is $5,500 per year and adjusting for inflation with a 3% return). Using the 4% withdrawal rule, results in a tax free supplementary income of $8,720/year. If retiring as a couple, that figure doubles to $17,440/year tax free.
Take care of your own retirement and you’ll just brush off the future changes that your employer makes. For those of you who have a defined benefit pension, are you supplementing your retirement with other investments?