Still holding an old pension? Here’s a smarter plan for Realtors
Do you have a pension from a past employer? If so, you may be able to receive more income from it later in life by making some changes now.
I was working for a young couple recently. David, age 33, is a Realtor now, but was a schoolteacher for seven years, from age 23 to 30. As a teacher, he accumulated pension money, which will provide him with an income stream in retirement.
There are many types of pensions, and the formulas differ for each. The income he eventually receives will be based on a formula.
In this case, they multiply his years of service by 1.9 per cent, and multiply that by the average of his last five years of salary.
The salary averaged $85,000, so David’s actual pension payout will be $85,000 x 1.9 per cent x seven years = $11,305 per year.
He becomes eligible to take the pension at age 55, but there are penalties for doing so. Taking it at age 60 is penalty-free. If the pension remains intact, we would recommend that.
Why the value of your pension may shrink over time
The problem here is that the lump sum of money within the pension will not grow between his last day of work as a teacher and age 60 when the pension commences. In twenty-seven years, it will be the same $11,305 per year. However, the cost of living rises most years, and on average, increases by about 3 per cent annually.
At that rate, the cost of living doubles every 24 years. In 24 years, David will be 57, nearly 60, and his pension’s purchasing power will be roughly cut in half. It will only buy him an estimated ~$5,653 worth of goods.
David can take the “commuted value,” essentially cash it out. Doing so means he assumes all of the investment risk. However, with a sensible approach, this is most likely the better move.
Evaluating the cash-out option: Risks and rewards
There are many ‘ifs’ in this, so we will have to generalize, but let’s assume he cashes out the pension, i.e., takes the commuted value.
The money is usually paid in three payments. One goes into a LIRA, a type of RRSP, but with a few more rules. Some goes into an RRSP, and some is immediately taxable. There are ways to mitigate that tax.
If the money is invested and earns six per cent per year after fees for 27 years, it will grow by a factor of 4.82, or, put another way, become almost five times as much money.
Allowing for three per cent inflation, it is less, but still grows 2.22 times as much. The LIRA and RRSP are tax-deferred accounts, meaning all investment returns are reinvested and none are subject to tax until the money is taken out.
Assuming inflation takes its usual toll, the pension will be worth about half as much, so the cash-out and invest himself strategy, given reasonable assumptions, would yield approximately four or five times as much income.
There are pros and cons. Making changes involves effort. Pensions often include extended health coverage for eyeglasses and medication, etc, or the option to purchase benefits at a very reduced rate.
Cashing out the pension means saying goodbye to those. Pensions are guaranteed. Your investment choices may not be. The younger you are, the more this strategy makes sense. Once you are over about age 47, you need a sharper pencil. Single parents may be better candidates for taking the commuted value.
There are many aspects to this decision, and the impact will be in the hundreds of thousands of dollars, possibly millions, so be careful. Decisions are not reversible. Speak with a competent and trusted advisor to evaluate if it’s good for you.
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