The Pros and Cons of Pension Income in Retirement
Pension income is a valuable source of retirement income that can provide financial security and stability for individuals in their later years. As a financial planner, I often advise clients on the benefits of pension income and how it can help to ensure that they can maintain their standard of living in retirement. By considering pension income as a part of a comprehensive retirement plan, individuals can ensure that they can live comfortably and securely in their golden years.
Benefits of pension income
Lower uncertainty means you’ll spend more money
The uncertain nature of the future makes retirement planning difficult. We don’t know how long we’ll live or what our investment returns will be. Because of that uncertainty, a prudent retiree must be cautious when spending their retirement savings to avoid running out.
Income from pensions has the benefit of helping mitigate those two risks. The payments will continue for as long as you live, and they are independent of the performance of the stock market. The combined effect of taming these two risks is that you’ll be able to confidently spend more in retirement.
According to a recent study titled "Guaranteed Income: A License to Spend" by David Blanchett, PhD, CFA, CFP® and Michael Finke PhD, CFP®, retirees will spend twice as much each year in retirement if they shift investment assets into guaranteed income wealth.
The simplicity of a lifetime paycheque
Managing income from pensions is also simple. You’ll receive a monthly payment and then decide how you’d like to spend it. Maybe you’ll save some for later, but your two basic choices once you begin your pension are to spend it or save it.
In contrast, if you have an investment portfolio that will be the basis of your retirement income, you will have a series of ongoing choices and questions:
Where should I invest the money?
Can I trust this investment advisor?
Are the fees that I’m paying too high?
Should I invest in the newest thing (crypto, ETFs, etc..)?
How much can I safely withdraw this year?
And the list goes on…
Most retirees will have a mix of pension and investment income, so investment decisions can't be fully avoided. However, the more you rely on investment income in retirement, the greater the importance of making the right investment decisions.
While having a bigger pool of investments allows for more spending flexibility, the cost of that flexibility is the continued need for financial literacy to make the most of your investments.
When the average investor earns a below-market return, just being average in your investing knowledge won’t cut it. To have a chance of achieving average results in the stock market, you’ll have to know enough to avoid making the common investing errors which drag down so many investor portfolios.
Staying on top of changes to the investing landscape is also something that retirees have difficulty with, as evidenced by the trend of a gradual decline in financial literacy with age.
Tax advantages
Finally, there are even tax benefits to some types of pension income.
Payments from eligible pension and annuity income are eligible for the pension income amount tax credit. The value of the tax savings varies by province and amount of pension income, but typically saves a few hundred dollars of tax each year.
Pension income splitting is another great tax benefit for retirees. If one spouse has lower income in retirement, pension splitting can help balance out taxable income and reduce overall taxes. The annual savings vary, but for a couple with a significant difference in taxable income, the savings could be as much as a few thousand dollars per year.
While income from a RIF or LIF account is eligible for these benefits at age 65, payments from a defined-benefit pension are eligible for them at any age. If you are considering taking the commuted value of your pension instead of the monthly payment, know that you will lose these tax benefits for the years before you turn 65.
Limitations of pension income
While there are many advantages to pension income, there are also some limitations to consider.
Survivor and estate issues
Many retirees are reluctant to convert their investments into pension income because they would like to leave money to children or grandchildren when they pass away. While there are typically options for pensions to continue making payments to a surviving spouse, the options available for other beneficiaries are limited.
When planning to leave assets as part of an estate, it can be helpful to divide the funds according to their intended purpose. Having a single pool of money that is intended for both retirement income and inheritance may not effectively achieve either goal.
If leaving an inheritance is important to you, it is even more important to make a deliberate choice on your level of pension income based on your needs. Once you’ve secured your own income in retirement, you can be more confident that you’ll be able to leave an inheritance or be able to assist your dependents while you’re still living.
Not having money when you want it
Another drawback of pension income is that if you have to exchange savings to get more pension income, there may be less cash available for spending in the early years of retirement.
Many retirees wish to travel and engage in hobbies early in retirement while still in good health. Having money available in early retirement to finance those expenses may be very important to some retirees.
In addition to having money available to spend more in early retirement, it is also desirable to have savings set aside for emergencies or other large expenses.
When considering the tradeoff between pension income and liquidity, it is important to consider your baseline level of pension income and the likelihood of needing a lump sum in the future. A temporary line of credit, for example, may be used as an alternative funding source in some situations.
It’s hard to exchange investments for pension income
After building up a lifetime of retirement savings it can be hard to make the switch from saving to spending. Additionally, it can be challenging to delay receiving income from sources such as Canada Pension Plan (CPP) or Old Age Security (OAS), which would reduce the need to withdraw from savings.
While not a drawback of pension income itself, it is important to recognize this as a potential source of discomfort that may arise when deferring government pension benefits. Having a written retirement plan and understanding the benefits of differing CPP and OAS can help ease the discomfort of seeing your investment balance decline.
Getting more pension income
Although fewer people now have a workplace defined-benefit pension plan, there are still methods to boost your pension income.
One way to do this is by delaying the start of your CPP or OAS benefits beyond the age of 65, which will result in higher future payments. Or, you could contribute to the CPP Post-Retirement Benefit.
Another option is to purchase an annuity, which can provide additional monthly income for those who have already decided to defer their CPP and OAS until the age of 70.
For those with a pension, there may be an option to increase your credits with a pension buyback.
Choosing your level of pension income
Pension income provides stability, simplicity, and the ability to spend more confidently. Retirees need to weigh the benefits and drawbacks of pension income and potentially increase the amount they receive to form a solid foundation for their retirement income. Ultimately, having a combination of pension and investment income may be the best approach to maximize retirement income and meet all your financial goals.
