Exploring Pension Options

As my regular readers know, a little more than a month ago my wife and I did the unthinkable for the average Canadian. We both quit our cushy full-time, gold-plated government pension jobs near Edmonton, Alberta. Then we sold and gave away 99 percent of our stuff, packed what was left in four suitcases and a few cardboard boxes, and moved approximately 11,000 km to the other side of the globe.

Our Journey

We are just getting settled in south east Asia as I write. It's taken a little adjustment in many ways. We moved from a comfortable, newly built suburban rowhouse surrounded by lush lawns and large nearby parks to an older—but newly renovated—apartment building in the middle of a large Vietnamese city. I've talked about the benefits of downsizing before, and I have zero regrets cutting our living space down by more than one-third once again.

Naturally we are renting. Renting provides ultimate flexibility and is a great way to make sure you are in control of your living expenses. There are no surprise costs, no maintenance fees, nothing. Just the monthly rent and an electric bill. This time our place is furnished (common for expat homes in our area).

We also getting used to the change in weather. Hot and sticky takes on a whole new meaning in south east Asia. There's little relief at night, early mornings are almost as humid as the day, and the smells of a large, developing tropical city hang in the moist air. I'm nearly accustomed now, but the first few whiffs are memorable.

The city environment is completely different here as well. True, nearly unfettered capitalism abounds! Everywhere you walk people are selling things. Fresh flower stalls. Small convenience groceries. A small food menu with a few tables. Large baskets of fruit on bicycles. Haircuts and shaves. There are hawker stalls on the sidewalks and many first floors of homes are converted into small shops and restaurants. The people here are hustling!

The best part is that it's working! In a country that was unthinkably poor just a couple decades ago, the common sight now is a local riding an imported motorcycle talking on a smartphone with a 4G data connection.

But onto the main point of this post: pension options!

The Math Behind Pension Options

While I still haven't received my pension options, my wife received hers. As promised, I wanted to share the numbers since it is my strong position that nearly everyone is better to cash out your pension than to take the monthly payments for life in our current financial environment.

In our particular plans, if you leave the plan early (more than 5 years of service but less than the "85 Factor" for a full pension) you have the option of taking a pension payout for the commuted value of your share in the plan, or leaving the pension in the plan and taking an estimated future benefit at age 55 or older.

I've adjusted the numbers because of privacy. Although I've shared my net worth for years, our pension payouts have a decent sized impact on our net worth. Also, I am currently building a new site where I will no longer be sharing our net worth every month. Instead, I will share my investment returns and let you guess where we stand.

Estimated Future Pension at 55: $485 per month (average of the different options)

Current Commuted Value: $100,000 ($65,000 in LIRA + $35,000 in cash)

Since we qualify a retirement at age 55 to be an early retirement, we need to assume that the future value of the commuted amount should be 25x our annual estimated future pension income. Because a government pension is theoretically highly secure, I would like to see a 30x multiple to be on the safe side.

To calculate our estimated future value, we need to make a few adjustments for tax. First, we will assume that our pension payment at age 55 within the plan will be taxed at 20 percent. Pensions are not very tax efficient and are taxed as regular income (with some splitting benefits).

Tax Adjusted Pension Benefit: $388 per month

This means the future value of the commuted pension adjusted for tax must exceed $139,680. That is the annualized benefit multiplied by 30.

Next, we need to adjust our commuted value for tax liabilities. I believe this is best done in two steps. First, we should adjust the cash portion right away as this is taxable upon payout. The tax charged for a non-resident is a flat 25 percent.

Tax Adjusted Current Commuted Value: $91,250 ($65,000 LIRA + $26,250 cash)

Next, we need to adjust our future investment returns on the cash portion for ongoing taxes. I will make a safe assumption that taxes will reduce returns on this portion by 1 percent annually. If we assume an inflation adjusted return of 5 percent for a portfolio over 27 years, the tax adjusted return on the cash portion will only be 4 percent annually.

Tax Adjusted Future Commuted Value: $318,363 ($242,675 LIRA + $75,688 cash)

Once again, we will adjust for taxes on the monthly income from the future commuted value. We'll assume the LIRA portion will be taxed at the same 20 percent. The cash portion will be taxed lower at 10 percent (capital gains and dividends will form a large part of the income).

Tax Adjusted Future Monthly Benefit for Commuted Value: $728 ($539 LIRA + $189 cash)

In the end, at an assumed gross inflation-adjusted return of 5 percent annually, you will be nearly twice as well off taking the commuted value and investing it yourself. In fact, if you can generate an inflation-adjusted return exceeding 2 percent per year, you are better off taking the commuted value.

As you can probably guess, my wife and I will be taking our share out of the pension plan and investing the commuted value on our own. First, I believe that I can achieve returns exceeding 2 percent annually after inflation. Second, I like to be in control of my own money.

Pension plans around the developed world are going through increasing pressure. Financial benefits are slowly being cut as current pensioners live far longer than expected and didn't contribute enough in their working years. In effect, many pension plans are the definition of a Ponzi scheme. The public pension system is also facing political pressures. I don't know what's going to happen the next time the world's financial markets get rocked in a 2008-esque moment, but I don't want my financial security subjected to the kind of political atmosphere I think may erupt. Taking the money out of the plan is another form of total risk control.

Comments & Questions

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Please visit my new website and blog for current posts on financial topics. DArends.com

The Unattainable

Is Early Retirement the real goal?

I discuss the topic of Early Retirement quite extensively on this blog. While it is not always at the forefront, it definitely lurks in the background. Spending, saving, investing... the accumulation of financial assets.

Early Retirement often evokes a bad image. To some, it suggests a capable person who is so incredibly lazy they want to be deliberately unproductive. To a neo-Marxist, an early retiree is the capitalist exploiter controlling means of production and living off the stolen labour of others.

Honestly, it is neither of these things and those who criticize Early Retirement from these broad positions either don't understand what Early Retirement actually is, or they deliberately choose to attack the idea because it is easier to attack another than discipline yourself.

Early Retirement is the pursuit of personal independence from the financial perspective. It is esacping from the necessity to work and do the bidding of others who actually have the ability to control. It is exactly what every capitalist, socialist, communist, individualist, collectivist wants: freedom. (However you define that word).

The difference is those who are willing to exercise great control over their personal lives and take calculated risks with the resources they've earned don't have it in their nature to complain about the success of someone else. When you don't worry about others, you can focus on bettering yourself.

Individuals who achieve Early Retirement standards by their own hard work and pursuit of a solid understanding of risk and investment are not going to sit in a hammock for decades and whither away like a discarded zucchini. The creativity and hard work required for personal financial success somehow tends to propagate more success in further ventures.

The great thing about Early Retirement is that it is entirely possible to achieve. That is precisely why I discuss the strategies in detail, track our own path and share that online, and continuously pore over tens of thousands of numbers in massive spreadsheets searching for better ways to invest money.

Canadians are way better off that we like to admit and we have massive potential to save, invest, and retire early without absolute reliance on government benefits. We just need to stop spending like fools.

No new vehicles, smaller houses, less furniture, less utilities, less restaurants, less convenience services, less clothes, less shoes, less household trinkets, less less less. The irony of course is that having less also means less stress which means a drastically better life overall.

The Investment Savings Rules

Lets talk truth when it comes to saving, investing, and Early Retirement.

If you plan to retire around age sixty where you expect some government benefits to come your way in the near future, you need to have invested an amount of money equal to at least 20 times your annual spending. That's $1,000,000 if you are spending $50,000 a year.

If you plan to retire earlier, you need to have invested at least 25 times your annual spending. That's $1.25 million if you are spending $50,000 a year.

If you want to be extra safe, never needing to work again, and are retiring young, you need to have invested 30 times your annual spending. That's $1.5 million if your are spending $50,000 a year.

Summed up, for the typical Canadian couple renting a house, you need to save and have invested between $1 million and $1.5 million. The amount would be around $300,000 less if you own a paid-off house.

Over a million dollars is a lot of money, so how do you get there?

The Importance of Early Discipline

Time and investment returns are a huge factor. The earlier you start saving and investing in productive assets, the better off you'll be and the easier it is. Also, the higher your investment returns are, the faster you will hit your goals.

While not impossible, it is not always easy to invest for higher returns. It requires even greater discipline and I view it as more of a bonus rather than a reliable factor in financial planning.

Assuming more standard 6% net returns after inflation, here are the monthly saving numbers required to make a comfortable retirement at age 55 happen.

Source: TheRichMoose.com

The older you start, the more difficult it is. If you start saving after you are thirty years old, you will likely never retire early barring amazing investment returns or some other financial windfall. Realistically there's only so much you can save when the typical household in Canada earns around $80,000 per year.

Some Advice for the Young(er than me)

The math, the power of compounding gains over time, clearly shows that the earlier you start saving and investing that money the better off you will be. This kind of thinking ahead can put you way in front of peers who follow conventional wisdom.

The destructiveness of acting like a teenager with your finances when you are well into your twenties or thirties cannot be made more clear by this chart. The exponential financial damage is huge. It ruins your personal freedom in ways that can't be totally computed.

I'm personally a huge fan of skipping university and picking a trade or apprenticeship educated career instead. If you graduate from high school and go directly into a trade, you can be a ticketed journeyman in your early 20s earning $30 to $50 per hour. You avoid student debt and the lavish lifestyle expectations that often come along with working in a field that is full of people with degrees. Trades careers present business ownership opportunities and specialization opportunities that you often can't find in many degree requiring fields.

But even if you do decide it is worthwhile for you to go to university, or if you are already on that path, it's not too late to make sure you are doing it correctly. Live how a student used to live (ie. poor). Work hard in the summer. Avoid student debt at all costs. Get a job right away, even if the pay isn't what your academic advisor promised it would be. Choose a degree in business, sciences, or engineering. Learn how to code or at least be savvy with tech stuff beyond simple user knowledge.

Comments & Questions

This is an archived post and all comments are disabled for management efficiency. You can email me for direct questions.

Please visit my new website and blog for current posts on financial topics. DArends.com