A client recently contacted us with the following concern: “I took some time off work for maternity leave when I had my child. Now I have returned to work, and I have been notified that I have the option to buy back my pension. What does this mean, and should I do it?”
A pension buyback, also referred to as a service buyback, is an agreement to purchase a period of prior service in your pension plan.
The first question is, why would someone do this? Quite simply, the reason to complete a pension buyback would be to increase your pensionable service under your pension plan. In turn, this would typically mean a higher pension in retirement, and/or an earlier retirement date.
Let’s take a closer look at pension buybacks, including the pros and cons, how it is done, and some key considerations to keep in mind when making this decision.
The Basics of Buybacks
There are some situations where an employee does not make contributions to their pension plan during their qualifying time period. For example, when an employee takes unpaid leave for a specific reason, such as maternity or paternity leave, an extended period of illness, or to care for a family member or loved one.
Although the employee may not have been collecting a salary at that time, and therefore not making pension contributions and accumulating pensionable service, they are still employed. Therefore, some pension plans allow the employee to make up for this lost time with a pension buyback. Note that employees do not have to calculate these amounts themselves, and can ask the pension plan administrator to calculate the cost of the buyback. This information is critical when deciding whether or not a pension buyback makes sense in your particular case.
How do You Buyback Your Pension?
If you’re given the option to complete a pension buyback, there are a couple of different sources of funds that can be used to complete the transaction:
- Cash – if you have the required amount of cash (non-registered) available, and you have the RRSP contribution room available, you can use cash to complete the buyback.
- Funds from your RRSP – if you have sufficient funds in your RRSP, you can complete the buyback with a direct transfer of funds from your RRSP to the pension plan.
- A combination of the two – cash and RRSP.
Note that, in order to use cash to complete a pension buyback, you must have adequate RRSP contribution room available. This is because pension contributions reduce RRSP contribution room, and the pension buyback is no different in this sense. Therefore, since a pension buyback will reduce RRSP contribution room (via a PSPA – Past Service Pension Adjustment), there must be adequate RRSP contribution room to begin with if you wish to complete the buyback with funds from your RRSP.
If you use funds that are already in your RRSP, there is no further adjustment to your RRSP contribution and no tax consequence of this transaction.
Advantages of Pension Buyback
There are several key advantages to completing a pension buyback:
- Increased pension contributions can increase the amount of pension benefit received in retirement;
- Increased pensionable service can allow for satisfying pension requirements by an earlier date and therefore achieving and earlier retirement;
- Matching employer contributions to a pension plan are mandatory, and therefore when an employee contributes, the employer must also contribute as well;
- The increased retirement pension benefit can also increase the survivor’s benefit (where applicable).
Disadvantages of Pension Buyback
As with most personal finance decisions, there are trade-offs to consider. Pension buybacks are no exception, as there are several disadvantages to this strategy as well:
- When funds are contributed to a defined benefit pension plan, the employee loses control over the investment of these funds. For some who do not want control, this may not be important. But for others who enjoy having control over their own retirement investments, this can be a significant disadvantage;
- Unlike an RRSP, where you can withdraw funds at any time, the funds in a pension plan are locked in and cannot be accessed until retirement, and even then are restricted and cannot be withdrawn like RRSP withdrawals;
- The decision is final, and the employee cannot subsequently change their mind as once the pension buyback is complete, it cannot be reversed;
- The additional value of the pension benefit achieved from the buyback is unknown in advance, and may end up being lower than the value of the funds used to complete the buyback. That is, left invested, the amount used to complete the buyback could potentially result in a greater retirement benefit.
Is a Buyback Right for You?
Given that everyone’s individual situation is unique, it’s important to evaluate your own personal circumstances to determine whether or not a pension buyback makes sense for you. Additional considerations include, but are not limited to:
- Life expectancy of the employee, and spouse (if applicable) – Those with a shorter than normal life expectancy may benefit from retaining control of the funds, whereas those with a longer than normal life expectancy may benefit from the buyback, as most defined benefit pension plans provide very strong protection against longevity risk (i.e. the risk of outliving your money);
- Health of the pension plan – Remember, pension plans aren’t guaranteed, and the promise made to pay benefits in retirement is only valid to the extent that the plan is properly funded. Retirees of companies such as Nortel Networks and Sears faced very difficult realities when, after a lifetime of dedicated service, ended up with far lower pensions than they were promised. As such, the strength, or more accurately the solvency ratio, of the pension plan is a key consideration;
- Amount and timing of retirement income needs – While some people favor a stable and consistent income stream, others have other priorities that may require significant amounts of capital at specific points in time, and therefore require greater flexibility in the timing and amounts of their retirement income payments than that which is offered by a pension.
Depending on your own unique circumstances, it may, or may not, be more appropriate for you to complete a pension buyback. If you have been presented with this option, and you’re wondering whether or not a pension buyback makes sense in your case, we can help you crunch the numbers and make an informed decision. If you would like to have a discussion with a Portfolio Manager or Certified Financial Planner, just contact us.