The pension buy back dilemma
Pension buy back really applies to those individuals who are part of a defined benefit pension plan and who may have missed out on some years of contribution service. Some examples might include a maternity leave, sabbatical, leave of absence or war service.
Buying credit improves your pension
There are only three ways to increase your pension plan income.
- Increase your income. In defined benefit plans, your pension income is closely tied to your earnings. Some plans look at your average earnings over the lifetime of your employment. Others take an average of the most recent years, like your last 5 years. Some might average your highest earnings. Whatever the case, you can’t go backwards and change the past.
- Get older. Age is often a contributor to something called the pension factor. For example, it is usually your years of service added to your age which will get you a higher pension factor. This might mean you will get a higher pension or it may also allow you to retire sooner with no reduction or penalties.
- More years of service. Obviously the last way is to increase your years of service by working longer. This is where the pension buy back can come in handy because you can go backwards and buy back years of service so you do not have to work longer.
Buying back pension credit provides you with the most pension you can have and can allow you to retire sooner. The more credit you accumulate, the greater your pension.
Doing the math
Whenever you are faced with the dilemma to buy back pension, it is important that you simply look at the numbers. You need to know if the cost now is worth the increased pension? The best way to find out is to compare the difference between what your pension will be-with and without your service purchase-at your normal retirement age.
There are no rules of thumb
The cost is unique to each individual. It depends on your age, your present salary, when the service you want to buy occurred amongst other things. The cost of a buy-back is the “actuarial value” of the service you’re purchasing – how much the future benefit is worth in today’s dollars.
Other issues to consider
When it comes to the buy back dilemma, the numbers will be the biggest determining factor. That being said, there are a myriad of other issues that will affect your decision to buy back pension. Consider some of these issues:
- Length of tenure. The longer you work for the same employer under a defined benefit plan, the more likely it will be that buying back pensionable years will be the best investment you can make. Defined benefit plans reward longer-term employees.
- Employer contributions. In most cases, buying back years of service also means that your employer will be making some contributions to your pension.
- Can you afford the cost? Obviously, this is one of the biggest issues. Often employers will help by allowing you to buy back the pension over a period of time rather than being forced to come up with one lump sum. If you have money in your RRSPs, you can also transfer the RRSP into the pension to buy back years of service.
- Estate planning. Pension plans will often provide some income to a spouse but the pension will not be passed on to your children. With RRSPs, there is an estate provided to beneficiaries other than your spouse.
- Flexibility and liquidity. As much as pensions are the cornerstone of retirement income for those belonging to a defined benefit plan, you will have greater flexibility and liquidity with other types of retirement savings like RRSPs. Pension funds are more restrictive.
- Time. Buying back pension later will result in a higher cost. The sooner you buy back pension, the less costly it will be. This is simply the time value of money.
- Life expectancy. Remember that pension income will pay for as long as you live no matter how long you live for. Although no one knows when they are going to die, keep in mind that if you think longevity is on your side, anything to do with the pension will weigh in your favour.
There you have some important considerations to think about if you are faced with the decision to buy back your pension. Most employers have calculators to help you make this decision. Alternatively, look for a retirement expert to help you make the best decision for your circumstances.