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Understanding Pensions By Example – Start Young, Don’t Wait For The Gray Hair!

Imagine this: You are a young professional without a care in the world talking to a group of people approaching retirement age. One of them mentions the word “pension” and your eyes immediately glaze over and your attention shifts elsewhere.

For young people, the word “pension” has just about the same appeal as “retirement”, “arthritis” or “cataracts”. Many people in their 20s and 30s simply can’t bring themselves to think about what life might be like 30 or 40 years down the road and how much income they’ll need to support their future lifestyle.

Every year we are bombarded by messages from the government and the banks to contribute to our RRSP, 401k or other retirement vehicle. We don’t tend to hear that much on the topic of pensions since they are not transaction oriented like RRSPs. Transactions equal profits for the big banks so they put out lots of marketing around RRSP time.

Related: What Is An RRSP?

RRSPs are made to look sexy, “Hey, I can get a tax refund !” where as a pension is something your 80 year old grandmother gets so she can pay her bills at the retirement home and feed her six cats. This unfortunately means that young people know lots about RRSPs but not much about pensions.

Since having a healthy income during retirement is vitally important, we should understand pensions, and how they differ from RRSPs. Basically, a pension gives you an income in retirement that was accumulated while you were working. Here is some background to help set the stage for the coming examples. Don’t get overwhelmed, there are a lot of variables to forecasting retirement income.

You may be thinking about the Canadian Pension Plan (CPP) and that since you’ve been paying into it your whole life, the government will take care of you. As you will see below, CPP is only one part of the retirement income picture.

Background

  • You have lived in Canada for 40 years  and as such, you qualify for full Old Age Security (OAS)
  • If you’ve lived in Canada for 10-39 years you can still get partial OAS
  • As a responsible, money savvy adult you have been contributing $5,000 per year to your RRSP and are earning a 5% return on those funds each year
  • The Canadian Pension Plan (CPP) earns a 3% return each year on the money they manage
  • The inflation rate from now until you retire is 2%
  • Your income is over the maximum pensionable earnings of $50,100
  • I used my own age in these calculations

Employer pension with no personal contributions

Let’s say you work for a big company that provides a Defined Contribution Plan (DCP) for your pension. Your employer’s program will contribute $5,000 per year to your pension.

At age 65, your yearly gross retirement income would look like this:

OAS

$6,540

CPP

$11,844

Employer Pension

$17,362

RRSPs draw down

$25,091

Total

$60,837

 

This looks like a very healthy income in retirement! You will of course have to pay taxes on this.

Employer pension with personal contributions

Many employers offer an additional benefit where they will match employee pension contributions up to a certain amount. Being a forward thinking individual, you decide to contribute an extra $1,000 per year so your employer will also contribute an extra $1,000.

At age 65, your yearly gross retirement income would look like this:

OAS

$6,540

CPP

$11,844

Defined Contribution Plan

$23,531

RRSP draw down

$25,091

Total

$67,006

 

So, for an extra $1,000 per year contribution, your income after the age of 65 will be $7,000 more!

Additional pension contribution vs higher RRSP contribution

What would happen if you contributed that extra $1,000 to your RRSP instead of to the pension plan with the added employer contributions?

At age 65, your yearly gross retirement income would look like this:

OAS

$6,540

CPP

$11,844

Defined Contribution Plan

$17,362

Planned RRSPs

$30,110

Total

$66,092

This is interesting, by missing out on the employer matched funds from your pension your income would be $1,000 less per year, but this isn’t that big of a difference considering you are missing out on a free $1,000 per year in matched contributions.

The reason for this is because we are assuming that your RRSP earns 5% per year vs 3% per year for the pension.

Related: Portfolio Update – Buying TD Bank

So should I contribute to my pension or my RRSP?

This is a hard question, the answer is different depending on many circumstances. Since pension funds are tasked with providing income for thousands of people in their retirement, they invest the pension funds very conservatively. As individuals, we tend to take more risk since we are only concerned about our own or our family’s finances.

So, if you have a long time horizon and are ok with taking on more risk, you should contribute more to your RRSP. If you are risk averse and are more comfortable with a big pension fund managing your money for you, contribute more to your employer pension and take advantage of the matching contributions. I always like to hedge my bets, so I would probably explore a hybrid approach and contribute some to both.

What if you don’t have a pension from your employer?

Now, imagine you are self employed or work for a company that does not provide a pension plan. If we use the first example, your income during retirement would be $43,475 per year! That’s $17,362 less income per year, a huge difference. People in this situation need to contribute more to their RRSP.

We all need to realize just how important pensions and RRSPs are to our later years. The sooner we understand these options, the better off we’ll be. So next time you are amongst a group of older people who are discussing pensions, listen up and contribute to the conversation!!

These calculations were prepared with this calculator from the Canadian Government.

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2 Responses to "Understanding Pensions By Example – Start Young, Don’t Wait For The Gray Hair!"

  1. Owen says:

    What about TFSA? I have one, but I’m sure it doesn’t get utilized properly. I’m told you can put it into mutual funds or gics; but just how does that work and where does it rank in comparison to the RRSP (my main savings are)?

    Also, I think RRSP’s have a nice advantage in the fact you can use the tax free money as a “loan” to buy your first house! I did this, so along with my contributions my employer also matches to a certain percentage. So in a round about way I got a discounted sum of money when I bought my house.

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