That's right. The pension plans that every socialist drools over and the right-wing anarcho-capitalists love to hate are really not an outsized deal.
Mediocre returns, high administration costs, bad investment strategies, political dabbling, I don't know... but when I do the math the numbers tell the same story over and over. I would be much better off investing on my own in a matching contribution-based plan than contributing to my supposedly gold-plated, defined-benefit government pension plan.
How Government Pensions Work
Government pension plans—or at least the ones that the media world tell you are so brutally unfair—are defined-benefit plans. You and your employer pay into the plan according to advanced calculations. Regardless of how the investments contained within the plan perform, you get a guaranteed pension benefit that's based on a percentage of your working income and your years of service under the pension plan.
Periodically, government pension authorities evaluate the sustainability of their pension plan and set contribution rates. These rates fall into two main categories: 1) a certain rate for employees and employers up to the CPP contribution limit [called YMPE - Yearly Maximum Pensionable Earnings], and 2) a higher rate for employees and employers above the YMPE limit.
The CPP limit—or YMPE—is factored into the calculation because once you turn 65, your pension benefits will be lowered according to your estimated CPP payments. For example if the plan calculates you will earn $1,000 a month from CPP, they will reduce your monthly pension benefit by about $1,000.
In my pension, one can retire and collect a benefit as early as 55 years old as long as they meet the "85 factor" (Age + Years of service >/= 85). This means you would have to start your career contributing to the pension plan at 25 years old to get the full benefit at 55 years old.
My Future Pension Estimate
Under the current rules, my pension benefit calculation goes like this: Average of Best 5 Years Salary x 2% x Years of Service = Best Annual Benefit.
At age 65 this is changed to a two part calculation for the CPP adjustment: (YMPE x 1.4% x Years of Service) + (Balance of Salary x 2% x Years of Service) = Total Pension Plan Benefit.
Assuming my salary goes up with inflation (it has been lower than inflation for the past decade now), at age 55 I will get a taxable benefit worth about $53,000 in today's dollars. After paying taxes at 19%, my net income will be around $42,900 if I retire in Alberta.
At age 65 when I get CPP, the pension benefit will be adjusted down to $23,219 + $20,560 for a total taxable benefit of $43,679 in today's dollars. I should note once I start collecting my pension the benefit only increases each year by 60% of the posted inflation rate so over time my real purchasing power goes down. Also, when I die my wife only gets 66% of the total benefit for the rest of her life. Our estate gets zilch when we both die.
Not bad at first glance considering I earn around $85,000 a year before a bit of overtime (overtime/extra pay is not included in the pension calculation). However, I should point out the benefit is fully taxable as regular income and I have zero control over my income mix, tax saving strategies, or coordinating my withdrawals with my actual expenses.
What If I Invested Myself?
The contribution rates to my pension are pretty high. About $420 biweekly comes directly from my salary plus $455 biweekly from my employer. That's a total adjusted contribution of $875 bi-weekly.
If I invested through Questrade according to a Growth Portfolio—which should return 6% annually after inflation over the long term—after 31 years my portion of contributions would be worth about $970,000 and my employer's contributions would be about $1,050,000 for a total value of a bit more than $2,000,000.
Following my 25x Rule (which gives me more than 92% chance of success when retiring at 55 years old), I would be able to withdraw $80,000 in my first year of retirement and adjust up each following year at the full rate of inflation. Plus I get no clawback at 65 years old for CPP. My wife would still get the full amount when I die. When we both die, our estate would get the total value of the portfolio which is very likely to be worth more than $2 million.
With a self-directed portfolio, I also am able to tax-optimize my withdrawals. Drawing some fully taxable income from RRSPs, tax advantaged Canadian dividend income from my Cash/Margin Account, tax advantaged capital gains income from my Cash/Margin Account, and non-declarable income from my TFSA, I could realistically pay a blended tax rate of 16% (or less) for a net income of $67,300.
Although my pension is pretty much guaranteed, it certainly isn't as lucrative as many believe it to be. To me a 92% guarantee with full adjustment for inflation, no CPP clawback, and a remaining balance for my estate is about as valuable as the 99% guarantee the government pension gives with only 60% inflation adjustment.
Using the same contribution rates in a self-managed, low-fee, index based Growth Portfolio, I would realistically be able to achieve almost 60% higher net income in retirement.
If the pension plan was able to follow the 25X Rule, the total value of my pension at age 55 should be $1.325 million ($53,000 x 25). The administrators should be able to achieve that with total biweekly contribution of $600 over 31 years instead of the current $875. It's almost certain that anyone contributing to a defined-benefit pension plan today is subsidizing the under-funded pension payments enjoyed by current retirees of those plans.
I realize it's definitely a controversial topic, especially considering many Canadians are about as financially literate as my fluffy and ever-so-cute pooch. "Guaranteed pensions" courtesy of the government is probably a decent deal for the average Canadian who would fall apart financially if their interest expenses went up a few hundred bucks a month.
I for one would not be upset if "the swamp was drained" and my fallaciously esteemed government pension was changed to a contribution based indexing plan open to all working Canadians. One can only dream.
Despite the large contributions I make to my government pension plan, which ultimately shrink my paycheque, I don't add my pension value in our Net Worth Updates. I feel it would throw off our true accomplishment: building a great investment portfolio out of what's left of our paycheques after taxes and those massive contributions.
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