Pros and Cons of Buying Back Pension Service
Do you have the option to buy back pension credits?
It seems expensive, but the benefits could be worth it.
Let's look at what buybacks are and the 6 factors you MUST consider when making this important decision.
Key Takeaways
A pension buyback will increase your pension and possibly allow you to retire earlier.
Factors such as health and total level of pension income can help you understand if this option might be right for you.
Pension buybacks are often time-sensitive. Don't delay or the cost may go up!
What is a Pension Buyback?
When you work for a company with a traditional (defined-benefit) pension, you make contributions to the pension with each paycheque. In some circumstances, you may be employed but not be paying into the pension.
Typical buyback situations:
maternity or paternity leave
term contracts before full employment
other unpaid leaves
After these periods are over, you may have the chance to "buy" your past pension service.
Example
Dave has been working as a hospital IT administrator for 9 years. He then took a year off for paternity leave after the birth of his daughter and did not contribute to the pension. When he returns to work, he will have been employed by the hospital for 10 years, but will only have 9 years of pension credits. This gap will reduce the pension he receives in retirement.
If Dave is eligible to buy back the past service, he would have the full 10 years of pension service as if he had contributed the entire time.
Benefits of Buying Back Service
There are two main benefits of buying back pension service:
Increase Your Pension
Defined-benefit pensions use a formula to calculate your retirement pension. The exact formula will vary from pension to pension, but the components are:
Your average salary
Your number of pensionable years
A multiplier
Buying back past service increases your pension by adding more pensionable years to the formula.
Ability to Retire Earlier
Many pensions use a formula to set your early retirement date. Retiring before this date would either not be allowed, or allowed but with a pension penalty.
A common early retirement formula is the "rule of 85".
To be eligible for early retirement under the rule of 85, you can retire once the combination of your age and years of service add up to 85.
(Age) + (Pension years) = 85
Buybacks help you get the minimum number of years faster.
Example
Barb is 57 and she has 26 years of pensionable service. Her pension follows the Rule of 85. Her current age plus service only adds to 83, so she would face a pension penalty if she retired now.
Earlier in her career, she had taken a total of 2 years of unpaid leave to care for her elderly parents. If she had bought the past service when she was eligible, she would have been able to retire now without penalty.
How to Pay for a Buyback
You can use cash or money in your RRSP to fund a pension buyback.
The simplest way to pay for a buyback is to make a direct transfer from an RRSP account.
If you wish to use cash, you will need to have enough RRSP contribution room available. Paying cash will result in a past service pension adjustment, which the CRA will need to certify before allowing the buyback. There are other tax complications with this option, so getting professional advice is recommended.
If you don't have enough RRSP room, you can also pay for the buyback with a combination of cash and direct RRSP transfer.
What are the Downsides?
Buybacks have benefits, but they are often very expensive. The cost is often in the tens of thousands of dollars or more. Because of this, it can sometimes be difficult to find the money to pay for them.
Some employers have the option for payroll deductions to fund the buyback, but a rate of interest is charged. This increases the overall cost of the buyback.
Another downside of buybacks is that the money contributed will be locked in the pension until retirement. This limits your flexibility to pay for other things in the short term. This is particularly important if you anticipate needing to take other unpaid leaves in the future.
6 Key Pension Buyback Considerations
It isn't easy to compare the benefits of a buyback against the cost.
To make the best choice, it should also be made within the context of your entire financial situation. Different financial planning assumptions can have a big impact on the results. A full comparison which includes income tax calculations is the best way to make an informed decision.
To quickly see if this might be right for you, take a look at these 6 factors:
Expected Longevity: Your pension will pay out in retirement for as long as you live. This makes your life expectancy a big factor in this decision. If you have health problems that significantly shorten your lifespan, you'll receive less benefit from increasing your pension income with a buyback.
Total Pension Income: Having more pension income goes a long way to protect you from the risk of outliving your money. If you don't have a lot of pension income already, the benefit of getting more from a buyback is an attractive option.
Comfort With Investing: Instead of using your cash or RRSP to buy back pension credits, you could instead invest it. While You MAY be able to earn a higher return by investing the money, it will come with RISK. If you're not comfortable with investing and taking risk, then it's less likely that your return will be higher than what you can expect from the buyback.
Will Your Employer Pay Too? For periods of regular employment, both you and your employer make contributions to the pension. But in some cases of buyback, you will need to pay for both employee AND employer portions of the buyback. Having to pay both portions can be very expensive. There is often a time window for when you only have to pay the single contribution rate. Don't miss your chance if this is an option you're considering!
Health of the Pension: Will your pension be able to pay out the full promised benefit when you retire? A pension's funded ratio is a measure of the plan's health. If the funded ratio dips below 100% it may be cause for concern.
Expected Salary Increases: One factor in the cost of buying back service is your current salary. But if you're expecting salary increases in the future, you might want to lock in the buyback at the lower salary. Otherwise, the buyback could be even more expensive later.
Don’t Delay
Pension buybacks are often time-sensitive decisions. Waiting too long could mean that you have to pay both portions of the buyback contributions.
If you need help weighing your options for retirement, set up a free introductory meeting with me.
