- How Does the Zero-Interest Rate Environment Affect You? - September 21, 2020
- Find Out the Commuted Value of Your Pension - September 14, 2020
- Reader Case: Rent or Buy in Spain - September 7, 2020
“OMG, You have no idea what just happened!” a friend recently texted us.
“What? What?” I texted back.
“I did what you suggested, and I just heard back from my HR department. All I can say is: WOW!”
Let me back up a bit.
Defined Benefit vs. Defined Contribution Pension
Over the years pensions in the private sector have largely gone the way of the dodo. Most companies these days, when they offer retirement benefits at all to their full-time employees, do it in the form of a defined contribution, or DC pension. How these work is that basically they top up, usually expressed as a percentage, your own contributions to your retirement accounts. So for example, if you put in a $1000 contribution into your RRSP or 401(k) plan from your paycheck, the company might chip in, say 50% or $500 extra up to a yearly cap. These are called defined contribution because how much the company contributes is explicitly defined. What you do with that money is up to you.
A traditional pension, on the other hand, is a defined benefit, or DB pension. With a defined benefit pension, the company (or more accurately, the company’s pension administrator) takes money out of each paycheck and invests it on your behalf inside a collective pension fund. Then when you retire at 65, the pension adminstrator pays out an amount to you each month for the rest of your life. These are called defined benefit because how much you receive each month in retirement, or your benefit, is explicitly defined. You don’t have to manage any investments yourself.
Defined benefit pensions are way, way, way more complicated (and more importantly, costly) to run. And as a result, most private companies no longer offer them.
However, some people still have them. We shall refer to these individuals as “Lucky Bastards.”
Maybe these Lucky Bastards work for a government agency, or at an employer with a long history that has pensions grandfathered into their benefits packages. Whatever the reason, these people still have access to these gold-plated dinosaurs that the rest of us peons can only dream of.
What Happens To A DB Pension When You Quit
Pensions are built assuming you work at the same company until you retire at 65, but as we all know this assumption is just a fantasy these days. People change jobs, get laid off, or quit with far more regularity than our Boomer parents. So nowadays, when employees either voluntarily or involuntarily say sayonara to their company, they get presented with a choice about what to do with the pension credits they’ve earned.
Option #1: Leave it With the Company
In this scenario, whatever you’ve earned in the pension you get to keep, but you obviously stop accruing more because you no longer work for that company anymore. Then, when you reach your normal retirement age of 65, you’re supposed to go back to the company and claim your benefit, at which point they start paying you your monthly payment. Obviously it won’t be as much money as if you worked there your entire career, but it’ll be something.
Option #1 is almost always the default option. The company really wants you to pick this option because a) they don’t have to do anything, and laziness always wins, and b) if you die before 65 or you forget to claim your pension when you turn 65, they get to keep your money.
Option #2: Transfer it To Another Company.
In this scenario, you leave your old company and go to a new company. If this new company also offers a DB pension, rather than start acruing from scratch all over again, you can apply to transfer the amount that you’ve accrued from your old pension into your new pension. So for example, if you worked for company A for 10 years, and then you switch jobs, you can take the 10 years of pension you’ve earned with company A and transfer it into company B. That way, your first year working in company B will accrue as if you’ve been working with company B for 10 years already.
This option is pretty rare in my old field (tech) because it requires that your old job has a DB pension, your new job has a DB pension, and that the two pensions are compatible enough to accept transfers from each other. Literally none of those assumptions apply in tech, and they don’t even apply that often in finance either, but in some fields this is a useful tool.
Teachers, for example, who transfer school boards can take advantage of this.
That’s literally the only example I can think of, though. That’s how rare pensions are these days.
Option #3: Take the Commuted Value
The third option is the interesting one. If your pension plan allows it, you can ask your pension administrator to calculate the pension’s commuted value, and then you can ask them to pay that amount to you personally.
Note that “commuted value” is not a universally used term. Some plans refer to it as “present value.” Other plans refer to it as “lump sum.” But the concept is the same. It refers to how much the pension would be worth right NOW as a sack of cash rather than the future promise of monthly payments.
Not every plan even offers this option. Every pension is different, so you have to ask. Generally in Canada, federally regulated pensions are required to offer this option, but in the US the pension has to be set up as a “cash-balance plan.” You have no control over what type of pension you have. Your employer chooses for you. So the first step if you’re reading this is to shoot your HR department a quick email and ask whether your pension (if you have one) can be cashed out in this way.
And finally, if you are eligible to receive the commuted value of your pension, there may be restrictions on when you can access it. In Canada, the money will go into a Locked-in Retirement Account (or LIRA) that places age-based restrictions on when you can withdraw the money. And in the US, the amount gets rolled into your IRA.
That being said, it’s still possible to access these locked-in amounts to fund your early retirement. If you’ve read our book, you’ll know that we came up with a technique to access the dividends earned in our LIRA called the Cash-Asset Swap. And for Americans, we also described a way to access your IRA using a technique called a 5-year Roth IRA Conversion Ladder. So restrictions be damned, gimme my money!
How much is the Commuted Value?
OK so now that we’ve explained Commuted Values and why it’s important, let’s get to the really important question: How big is my sack of cash?!?
And annoyingly, the answer is: it depends.
How your commuted value is determined is not a simple formula. Actuarial software needs to get involved, and a good general rule is that once actuarial anything needs to get invovled, things get confusing super-fast.
Don’t worry, I won’t make you read MATLAB code. I did it for you. Here’s what I learned are the major factors that determine your pension’s commuted value.
The more you earn, the more your pension will be worth. Pretty intuitive, because your pension contributions are a percentage of your earnings, so the more you contribute each paycheck, the more your pension payouts will be. Again, pretty intuitive, so lets move on.
Years of Service
Again, pretty intuitive. The more time you worked at a company, the bigger your pension will be, and the more your commuted value will be worth.
Your Life Expentency
This is the part where the actuaries get all turned on. This is the part where the actuarial software takes in your age, race, how much you smoke, etc. and figures out how long you’re likely to live. The longer you’re expected to live, the more your pension will be.
And finally, interest rates. Pensions are madated to provide steady, guaranteed income to their clients for as long as they live, and the only way to get guaranteed income is for the pension funds to invest part of their money in bonds.
That’s why interest rates matter. If safe, secure government bonds are paying a ridiculously high interest rate, like 10% in the 80’s, then your pension doesn’t need to be worth that much money. But if interest rates are low, then the regulations that govern pensions would cause the commuted value of that pension to be much, much higher.
Email Your HR Department!
The first 3 factors in that calculation aren’t that interesting. Having a higher salary and working longer are obvious ways of increasing your net worth, but both of those factors are out of your control right now during this shitty, shitty year. Your life expentency is also largely out of your control.
But you know what’s in a ditch right now? Interest rates.
In every major economy in the world, central banks have dropped their interest rates down to damned-near zero. As a result, savings accounts have been massacred. Mortgage rates have also crashed causing a strange, unintuitive jump in housing prices, and it’s also caused people’s commuted value of their DB pensions to skyrocket.
In other words, when interest rates are unbelievably low (like right now), your lump sum could be insanely high.
“Holy shit!” our friend giggled as she sent us a screenshot of our pension statement.
It was multiple times her annual salary.
“I think…” I scratched my head, staring at the number of zeros on my phone. “I think you just became FI…”
So if your workplace has a pension, ask them for you commuted value right now. You might be a lot closer to FIRE than you think.
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