Are Canadian pension buybacks worth it?
Ask MoneySense
I am currently transferring my pension from a provincial to a federal government pension plan. I’m trying to determine if it is worth purchasing the balance of service and, if so, should I use my RRSP or TFSA funds. Here’s some relevant info:
- Service Credited: 7 years, 140 days
- Balance of Service to purchase: 1 year, 323 days
- Lump sum cost for balance: $29,146.19
–Jason
Pension buybacks: yes or no?
Jason, I can understand why you’re asking this question. Most Canadians will know that a good defined benefit (DB) pension plan will pay a guaranteed income for life. And, in some cases that income is indexed. However, if I were to ask how that pension income was formulated, most people wouldn’t know. But, that’s what is needed to answer the question if a pension buyback is worth it.
Usually when Canadians buy past service (supplementing a pension), it is due to a work absence—often a leave of a year or two. There are statutory, or protected reasons for missing work, such as disability, maternity or parental leave, and non-protected absences, like, say, a leave of absence to travel as a family or take care of a loved one. Purchasing past service is always available when an absence is considered a statutory reason but may not be available for non-protected absences.
In your case, Jason, you are transferring a pension plan to one that is more generous. Not enough money was contributed to match the benefits of the plan you’re joining, so to match the plan you will have to contribute more in the form of a pension buyback.
Warning, explicit math content
Now, let’s dig into the inner workings of a pension, so you can make this decision. I don’t have all the details of your pension, so, for simplicity’s sake, I will work with a typical pension plan and assume the reason for the buy back is due to time away from work rather than transferring from one pension to another.
The first thing you need to know is how much you contribute to your pension plan. If you search for your pension plan online, “calculating your contributions,” you will see one or a combination of these results:
- You contribute 10.4% of your annual salary up to the CPP (Canada Pension Plan) limit, plus 12% of any salary above the CPP limit, currently $66,600.
How much are you adding to your registered retirement savings plan (RRSP) to build your own pension? For those Canadians without pension plans, note that the above plan requires employees to contribute more than 10% of their gross annual pay toward their pension. - There is a qualifying factor of 85, age plus years of service. For example, if you are 53 with 32 years of service, then you reached the “85 factor,” which is 53 years of age, plus 32 years of service.
- Unreduced pension (retiring early with no change to retirement income) is calculated as 2% multiplied by years of credit multiplied by the average of the best five years. That is your lifetime pension plus bridge benefit. Once you turn 65, there is a CPP adjustment of 0.45%, so the 2% in the previous example becomes 1.55%, which is your lifetime pension without the bridge.
Calculating the value of pension buy backs
Jason, it’s time to figure out what this means for you, and how it can help you make your decision to opt for the pension buyback or not.
The first step: Figure out the value of your pension when you reach 65, based on your current years worked. This will tell you what you are actually purchasing. I’m going to assume you started working seven years ago at age 25 and have an annual salary of $90,000.
Using the third formula, we have:
1.55% x salary up to the yearly maximum pensionable earnings (YMPE) or CPP limit ($66,600) = $1,032
2% x salary over the YMPE ($90,000 – $66,600) = $468
Adding these two together totals $1,500, which means that every year you work, you add an additional $1,500 to your lifetime pension. Because you have already worked seven years, your pension at age 65 will be $10,500 a year (7 x $1,500), not including adjustments for inflation.
Now use formula 1 to figure out the cost to buy back one year worth of service.
10.4% on salary up to the CPP limit 66,600 = $6,926
12.0% on salary over the CPP limit of $66,600 = $2,808
Total $6,926 + $2,808 = $9,734
There it is. To purchase one year of pension income, in this example, it will cost you $9,734.
So, the question is, Jason: Is it worth drawing $9,734 from your investments to increase your pension by $1,500 a year, indexed for life?
That’s the math. Here’s is a buyback calculator from Public Service Pension, if you want to check it out.
The 85 factor for Canadian retirees
The math for the 85 factor is simpler and the ability to retire sooner, if you purchase your past pension, than the above calculations.
Remember, starting work at 25 and working for 30 years (to age 55) brings you to the 85 factor and the ability to retire with an unreduced pension. If you miss a year of work and don’t buy back the pension, you will have to work an extra six months to hit the 85 factor.
55.5 age + 25.5 years of service = 85
Should you use your RRSP or tax-free savings account (TFSA) to buy back service? That depends on your situation.
If you transfer money from your RRSP, you won’t get a second tax deduction, and you will lose that RRSP contribution room.
If you use your TFSA, you will get a tax deduction and you can add that money back to your TFSA in future years.
Should you purchase a pension buy back?
Jason, I haven’t answered your question yet. But, here’s my thought: In most cases it makes sense to purchase past pension. It’s a guaranteed income for life and, in your case, indexed. Plus, you can also retire a little earlier with an unreduced pension. If you don’t buy back the pension, you’re taking an investment risk. And when the day to retire comes, it is often psychologically more difficult to spend money coming from investments rather than from a pension.
Read more on pensions:
- Should you include your pension in your net worth?
- Should you cash out your workplace pension when you leave a job?
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