Understand your pension options in three simple stepsThere are many situations where individuals are asked to make decisions regarding their pension benefits. These can include:
- They belong to a Defined Benefit (DB) pension plan and are trying to decide whether to take a lump-sum payment or a pension from the plan
- They belong to a Defined Contribution (DC) pension plan or an RRSP and are trying to decide when to start receiving income from their plans
- They are looking at the Canada Pension Plan (particularly with the new rules that were introduced on January 1, 2011) and are trying to decide when to start taking their payments
- They belong to a major public sector DB pension plan and have the option of purchasing some additional past service
- They are a member of a pension plan which is being redesigned and have some choices to make about their pension coverage.
For clarification, a Defined Benefit pension plan is one in which the pension is provided based on a formula, which normally involves credited service and earnings. A Defined Contribution pension plan is one in which the plan sponsor (and frequently the member) makes an annual contribution to the plan and the benefit is based upon the accumulated value of these contributions at retirement.
Many people find these decisions difficult and the whole issue of pensions to be boring in the extreme. However, they should realise that the decisions they make can have a significant impact on the incomes they will receive for the balance of their lives. So how can we make this process relatively painless? I generally think of this as a three step thought process:
- Make sure you fully understand the choices available to you and the implications of those choices. Many people do not understand pension terminology and misunderstand the options available to them. For example, a pension payable with a five year guarantee does not imply that the pension is only payable for five years. It is payable for life, with an additional guarantee that the first 60 months of payments are guaranteed, even if the recipient dies.
- Compare yourself to the “average” plan member and see how this might influence your decision. Most pension options are based on actuarial factors which represent the “average” person. Few of my clients are average! To the extent that you may come from a family with long life expectancy, or have a spouse or partner who is significantly older or younger than you, you should make sure that the calculations are working in your favour.
- Consider the overall context in which the decision is being made. Pension decisions do not exist in isolation. So ask yourself, what else is going on in your life which might affect the decision? Do you have a need for a large guaranteed income at a certain age, or is your lifestyle fairly frugal? Are you a risk taker, or do you lose sleep at night worrying about your investments?
If you are seeking the help of a professional in dealing with one of these decisions you should first ask yourself:
- Is this person familiar with pension terminology and really able to help me?
- How are they being compensated for the advice they are giving me?
- Does this create any bias in the option they may recommend?
Finally, do not be overwhelmed by large numbers. In choosing between a lump sum and a pension it is often tempting to go for the lump sum. But the value of a pension for life, particularly one that is indexed to the cost of living, may actually exceed the value to you of the lump sum. Hopefully, if you follow the three step process, you will arrive at decisions that work for you.
Patrick Longhurst, CFP