5 pension plans

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I_____________________________________________________________ NTRODUCTION Many of us depend upon our pension plans to provide adequate income during our retirement years. Some of us have “Defined Benefit” plans while others have “Defined Contribution” plans. There are big differences between the two types. The major difference of concern to us is the amount of income the two types will produce during our retirement - will it be enough to allow us to live the lifestyle we want?

Another major concern is whether there will be adequate funds in our pension plans to continue paying out the income we expect. _____________________________________________________________

A defined benefit pension plan is a major type of pension plan in which an employer/sponsor promises a specified monthly benefit on retirement that is predetermined by a formula based on the employee's earnings history, tenure of service and age, rather than depending directly on individual investment returns. It is 'defined' in the sense that the benefit formula is defined and known in advance.

The most common type of formula used is based on the employee’s terminal earnings (final salary). Under this formula, benefits are based on a percentage of average earnings during a specified number of years at the end of a worker’s career.

Defined benefit plans distribute their benefits through life annuities. In a life annuity, employees receive equal periodic benefit payments (monthly, quarterly, etc.) for the rest of their _____________________________________________________________ Profitable Planning & Management Inc. Page 55

Pension Plans

D EFINED BENEFIT PLANS _____________________________________________________________

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lives. A defined benefit pension plan allows joint distributions so a surviving spouse can still receive 50 percent of your payment.

The benefit in a defined benefit pension plan is determined by a formula that can incorporate the employee's pay, years of employment, age at retirement, and other factors. A simple example is a Dollars Times Service plan design that provides a certain amount per month based on the time an employee works for a company. For example, a plan offering $100 a month per year of service would provide $3,000 per month to a retiree with 30 years of service. While this type of plan is popular among unionized workers, Final Average Pay (FAP) remains the most common type of defined benefit plan offered in the United States. In FAP plans, the average salary over the final years of an employee's career determines the benefit amount.43 _____________________________________________________________

Inflation

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Pension Plans

Frequently, as in Canadian government employees' pensions, the average salary uses current dollars. This results in inflation in the averaging years decreasing the cost and purchasing power of the pension. This can be avoided by converting salaries to dollars of the first year of retirement and then averaging. If that is done then inflation has no direct effect on the purchasing power and cost of the pension at the outset.

In the United Kingdom, benefits are typically indexed for inflation (known as Retail Prices Index (RPI)) as required by law for registered pension plans. Inflation during an employee's retirement affects the purchasing power of the 43

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pension; the higher the inflation rate, the lower the purchasing power of a fixed annual pension. This effect can be mitigated by providing annual increases to the pension at the rate of inflation (usually capped, for instance at 5% in any given year). This method is advantageous for the employee since it stabilizes the purchasing power of pensions to some extent.44 _____________________________________________________________

Funding

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Defined benefit plans may be either funded or unfunded.

In a funded plan, contributions from the employer, and sometimes also from plan members, are invested in a fund towards meeting the benefits. The contributions are set up so that if absolutely everything goes according to assumptions for all future years, then the full present value of future benefits (PVFB) is in the assets as each participant retires.

Stated differently, if I am a participant in a funded plan, then the contributions are set up so that the full amount of money needed to pay my benefits for the rest of my life is in the

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In an unfunded defined benefit pension, no assets are set aside and the benefits are paid for by the employer or other pension sponsor as and when they are paid. This method of financing is known as Pay-as-you-go (PAYGO or PAYG). In the US, ERISA explicitly forbids PAYGO for private sector, qualified, defined benefit plans.

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trust assets by the time I retire. This is the biggest different between funded and unfunded plans. 45 _____________________________________________________________

D EFINED CONTRIBUTION PLANS _____________________________________________________________ In a defined contribution plan, fixed contributions are paid into an individual account by employers and employees. The contributions are then invested, for example in the stock market, and the returns on the investment (which may be positive or negative) are credited to the individual's account.

On retirement, the member's account is used to provide retirement benefits, sometimes through the purchase of an annuity which then provides a regular income.

Pension Plans

In a defined contribution plan, investment risk and investment rewards are assumed by each individual/ employee/retiree and not by the sponsor/employer. This risk could be substantial. Based on simulations from security returns over the twentieth century across 16 countries, there is considerable variation in pension fund ratios across both time and country. Those countries keenest on individual defined contribution pension accounts have the highest pension fund ratios (e.g. the UK, the USA), but all investors in all countries face considerable downside risk.

The "cost" of a defined contribution plan is readily calculated, but the benefit from a defined contribution plan depends upon the account balance at the time an employee is looking to use the assets. So, for this arrangement, the contribution is known but the benefit is unknown (until calculated).46

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Creating A Pension

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With a Defined Contribution pension plan, when you retire, the funds are transferred to a Locked-In Retirement Account (LIRA), usually with a large insurance company. You don’t have any choice. The laws of the land stipulate that the money has to be put into a LIRA that must be converted to a Life Annuity during the year you have your 71st birthday.

The payment stream from the issuer to the annuitant has an unknown duration based principally upon the date of death of the annuitant. At this point the contract will terminate and the remainder of the fund accumulated is forfeited unless there are other annuitants or beneficiaries in the contract.

Thus a life annuity is a form of longevity insurance, where the uncertainty of an individual's lifespan is transferred from the individual to the insurer, which reduces its own uncertainty by pooling many clients. Annuities can be purchased to provide an income during retirement.

Canada In Canada the most common type of annuity is the life annuity, which is normally purchased by persons at their retirement age with tax-sheltered funds or with savings funds. The monthly payments from annuities with taxsheltered funds are fully taxable when withdrawn as neither _____________________________________________________________ Profitable Planning & Management Inc. Page 59

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A life annuity is a financial contract in the form of an insurance product according to which a seller (issuer) — typically a financial institution such as a life insurance company — makes a series of future payments to a buyer (annuitant) in exchange for the immediate payment of a lump sum (single-payment annuity) or a series of regular payments (regular-payment annuity), prior to the onset of the annuity.

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the capital or return thereon has been taxed in any way.

Conversely income from annuities purchased with savings funds is divided between the return of capital and interest earned, with only the latter being taxable.

An annuity can be a single life annuity or a joint life annuity where the payments are guaranteed until the death of the second annuitant. It is regarded as ideal for retirees as it is the only income of any financial product that is fully guaranteed. In addition, while the monthly payments are for the upkeep and enjoyment of the annuitants, any guaranteed payments on non-registered annuities are continued to beneficiaries after the second death. This way the balance of the guaranteed payments supports family members and becomes a two-generation income.

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United States With a "single premium" or "immediate" annuity, the "annuitant" pays for the annuity with a single lump sum. The annuity starts making regular payments to the annuitant within a year. A common use of a single premium annuity is as a destination for roll-over retirement savings upon retirement. In such a case, a retiree withdraws all of the money he/she has saved during working life in, for example, an Individual Retirement Account (IRA), and uses the money to buy an annuity whose payments will replace the retiree's wage payments for the rest of his/her life. The advantage of such an annuity is that the annuitant has a guaranteed income for life, whereas if the retiree were instead to withdraw money regularly from the retirement account (income drawdown), he/she might run out of money before death, or alternatively not have as much to spend while alive as could have been possible with an annuity purchase.

The disadvantage of such an annuity is that the election is irrevocable and, because of inflation, a guaranteed income _____________________________________________________________ Profitable Planning & Management Inc. Page 60

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for life is not the same thing as guaranteeing a comfortable income for life.47 _____________________________________________________________

Inflation

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As we saw in Chapter 3, “Inflation”, if inflation is averaging 4%, we will need to earn the amounts shown on this bar chart 10 to 60 years from now to maintain today’s buying power of $5,000 per month.

So, during your expected 30 years of retirement, your monthly income requirements will rise, for example, from $5,000 per month today to $7,400 in the 10th year to $10,955 in your 20th year to $16,215 in your 30th year.

However, in a defined contribution pension plan, there is no allowance for inflation. The size of the annuity that you set up when you retire is fixed meaning that all future monthly payments will be identical with no increases to compensate for rising costs due to inflation.

To put it another way, in your 20th year, the buying power of your monthly pension payments will be cut in half.

47 http://en.wikipedia.org/wiki/Life_annuity (Sunday, 31 March 2013) _____________________________________________________________ Profitable Planning & Management Inc. Page 61

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Dotted line indicates $5,000.

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If inflation is averaging 2%, the buying power of your monthly pension payments will be cut by a third in your 20th year as shown on this bar chart.

Dotted line indicates $5,000.

You will need $7,430 to equal the buying power of $5,000 when you retired. If you’re receiving only $5,000 in your 20th year, your buying power has decreased to the equivalent of $3,338 when you initially retired. _____________________________________________________________

Funding Pension Plans

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You might recall reading in the introduction that the Credit Suisse Global Investment Returns Yearbook, in the February 2012 update, reported that a globally diversified portfolio of stocks grew in value by an average of 8.5% per year between 1900 and 2011. 48 However, in Canada, the Toronto Stock Exchange Composite Index has declined by 15% or more 7 times and declined by 25% or more 4 times in the last 20 years.49 That’s eleven major declines in 20 years. If you live in the United States and many other countries around the world, there’s the Great Recession to think about.

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The Blue Chip Report, January 2013,Tony Demarin, MBA, CFA, CIM, FCSI - www.bcvassetmanagement.com (Monday, 18 March 2013) 49 The Blue Chip Report, January 2013,Tony Demarin, MBA, CFA, CIM, FCSI - www.bcvassetmanagement.com (Monday, 18 March 2013 _____________________________________________________________ Profitable Planning & Management Inc. Page 62

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If you happen to retire during a large decline in the stock market, the value of your pension account will be considerably lower than during a peak period for the stock market. Thus, the size of the annuity that you set up for your pension payments will be lower and your monthly income during retirement will be lower.

In the worst case scenario where the stock market has declined by 25% or more, your monthly payments could be at least 25% lower than if you happened to retire at a peak in the stock market.

Should your economic well-being be left to chance? _____________________________________________________________

Personal Experience

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After she retired in the early part of 2008, her employer transferred the pension funds to an insurance company in June 2008. Since then, the fund has been managed by one of the better, if not the best, money managers in our area.

After 59 months, the fund has grown at an average rate of 4.2%.

However, it’s been a roller-coaster ride as you can see on the bar chart on the next page.

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My wife worked for a company with a Defined Benefit pension plan.

When she retired, the funds were transferred to a Locked-In Retirement Account (LIRA) with a large insurance company. As stipulated by law, during the year she has her 71st birthday, the LIRA will be converted to a Life Annuity.

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During that 59 months, inflation in Canada has averaged 1.42%50 as indicated by the wavy horizontal line near the top of the bar chart.

Items that cost $100.00 in 2008 now cost $107.33 (2013). To maintain her buying power from the beginning, the fund value would have to be at or above the inflation-adjusted line.

After the first eight months, the fund had lost 34.3% of its value. If the LIRA had been converted to a Life Annuity at that time, her monthly pension would have been 34.3% lower than if she had converted the funds to an annuity at the beginning.

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The fund value finally got back above the inflation line after 21 months. However, since then it has been below the inflation line several times. In total, the fund value has fallen below the inflationadjusted value during 34 months. The fund value has not kept pace with inflation for 57.6% of the time!

If that trend continues, my wife has a less than 50/50 chance of converting her LIRA to a Life Annuity when the value of the fund is equal to or better than the original value adjusted for inflation.

In addition, the Life Annuity is a constant monthly value. It will not be adjusted for inflation. The buying power of her monthly cheque will decrease every month. Even a 2% rate of inflation will cut her buying power by a third in 20 years.

50 http://www.bankofcanada.ca/rates/related/inflation-calculator/ _____________________________________________________________ Profitable Planning & Management Inc. Page 64

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Dotted line indicates $5,000. _____________________________________________________________

W ILL OUR PENSION INCOME BE ENOUGH? _____________________________________________________________

Because many expenses will go down: • Work-related expenses such as work clothing and commuting will disappear.

• You will likely pay less tax.

• You will no longer be contributing to a workplace pension plan (or to the Canada or Quebec pension plan), and no longer paying union or professional association dues.

• You may move to a smaller home that costs less to purchase and maintain.

On the other hand, costs for health care and social and recreational activities may go up. 51

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Most professional financial advisers will tell us to save enough money to cover 70 to 80 per cent of our pre-retirement income. Why do they suggest less income after retiring?

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If your pre-retirement income was $70,000, most number crunchers recommend you should be able to maintain your lifestyle on about $49,000 per year in retirement income.

Government benefits will make up almost a third of that total.

The rest – well, it's up to you.52 In the example above, for someone earning $70,000 during their last year of working, they would need $49,000 income per year of retirement of which 68% or $33,320 would come from their own savings. To generate $33,320 per year ($2,777 per month), they would need the following amounts in savings or investments: $416,500 at 8%, $555,333 at 6% or $1,110,667 at 3%.

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As we know from Chapter 3, inflation will affect the buying power of their income. As shown on the bar chart below, they will need $3,385 per month in their 10th year, $4,126 in their 20th year and $5,030 in their 30th year to have the same buying power as the $2,777 in their first year of retirement.

Dotted line indicates $2,777. _____________________________________________________________

Personal Experience

I served in the Royal Canadian Air Force for 27 years. Because I lost my medical status, I could no longer work as a Pilot so had to leave the military at the age of 48 vs 55. That meant I was eligible for a pension equal to only 75% of what I would have received at age 55.

So, at age 48, my gross income suddenly dropped by half.

There’s two lessons in the previous paragraph: • we might not be employable as long as we had planned; and • our pension income might be a lot less than we thought it would be.

We should have another backup plan working for us.

A small, part-time, home-based business with the potential to keep growing even after we quit working at it is a viable plan worthy of further consideration. _____________________________________________________________ Profitable Planning & Management Inc. Page 67

Pension Plans

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I_____________________________________________________________ S OUR PENSION PROPERLY FUNDED? Many pension plans are not properly funded meaning there will not be enough money in the plan to pay many of us what we are expecting. One well known example is the iconic Ontario Teachers’ Pension Plan (OTPP).

The average teacher is likely to draw a pension — geared to their best five years’ earnings — for more years than they will work. So the OTPP’s liabilities have been outrunning its investment returns. Its 2011 annual report showed an unfunded liability of $45.5 billion. Scary — not least because non-teachers are also living longer and getting lower investment returns.53 Unfunded liability means there’s not enough money in the plan to pay the promised pensions in full.

Pension Plans

Across the United States, state and local governmentsponsored pension plans are in trouble. They are dangerously underfunded to the extent that their assets are unable to meet future liabilities without either outsize investment returns or huge cash infusions. Over the past several years, estimates of the total size of the public pension problem in the U.S. have ranged from $730 billion in unfunded liabilities to $4.4 trillion. Many financial economists believe that the true size of the total unfunded liability lies closer to the larger estimates than it does to the smaller.54 Here’s another example reported in The Globe and Mail September 17, 2013 under the headline “Alberta tackles pension costs”.

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Alberta is setting a dramatic course to rein in the surging costs of public pensions, including actively discouraging early retirement and cutting cost-of-living increases.

The effort to contain the cost of Alberta’s four separate public pension plans, with unfunded liabilities of more than $7.4billion, is being called the boldest move yet on an issue facing governments across the country – finding a way to pay for pensions even as work forces age, life spans grow, investment returns from markets fall, and the pressure on public finances rises.55

Canadians who have lived a century are the fastest-growing segment of the population. The 2011 census counted 5,800 centenarians, a number that is on track to grow to 78,300 in 2061. That is enough hundred-year-olds to match the population of Sault Ste. Marie. These remarkable lifespans are stretching the resources of pension plans that were never designed to support so many elderly members. In the not too distant future, the average retiree will spend more time collecting their pensions than they did contributing to them during their careers. Our pension designers never anticipated this trend.56 55

http://www.theglobeandmail.com/news/politics/alberta-tackles-pensioncosts-with-sweeping-reforms/article14366399/ (Friday 27 September 2013) 56 Jim Leech & Jacquie McNish, The Third Rail (Toronto: McClelland & Stewart, 2013), 20 _____________________________________________________________ Profitable Planning & Management Inc. Page 69

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Note the words “an issue facing governments across the country – finding a way to pay for pensions even as work forces age, life spans grow, investment returns from markets fall, and the pressure on public finances rises”. This not an isolated problem affecting only a few people.

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This issue will affect most of us. If pensions cannot meet people’s needs, they will hang onto their jobs longer or return to work thus competing with younger people for jobs. If pensions aren’t meeting people’s needs, they will not be buying as many consumer goods and they will not be travelling. All business sectors and most people of all ages will feel the financial effects.

For a more in-depth look at pensions and the looming crisis, read The Third Rail: Confronting Our Pension Failures, by Jim Leech, head of the Ontario Teachers’ Pension Plan, and The Globe and Mail’s Jacquie McNish. 57 _____________________________________________________________

Are You Financially Secure?

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Many of us will not have enough money saved to pay for the lifestyle we want during retirement. Currently, 57% of people over 50 need to work after retiring because of financial need.

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ThirdQuarter surveyed individuals regarding the reasons they were either looking for work or had decided to remain in the workforce. . . . 16% identified a financial need and 41% indicated both a financial need of some kind as well as a desire to work.58

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S UMMARY _____________________________________________________________ There are big differences between “Defined Benefit” and “Defined Contribution” plans.

Defined Benefit plans can include a feature that adjusts the monthly payments each year to compensate for the effects of inflation.

Defined Contribution plans usually do not include adjustments for inflation.

In addition, the value of the income derived from a Defined Contribution plan can vary greatly depending upon the value of the invested funds at the time of conversion to a LIRA and a Life Annuity.

While investing our money into our pension plan at work is a valuable part of any retirement planning package, I think having a part-time, home-based business should also be part of the package.

Look for a business that suits your personality and has the potential to provide passive income for the rest of your life and perhaps for future generations.

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Pension Plans

Many pension plans are not properly funded meaning there will not be enough money in the plans to pay many of us what we are expecting.