No pension? No problem

Thanks to the market crash in late 2008, Canada has seen a nasty surge in pension jealousy lately. The workers being envied are those with defined benefit pensions which promise a lifetime of set payments, no matter what happens in the markets. Among those turning green are the disappointed workers with group RRSPs and defined contribution pensions, who saw huge chunks of their retirement savings vaporize overnight when the market crashed.

If you’re in the latter group, you likely feel slighted—that the public and private sector workers with their rock-solid defined benefit pensions have it better. And the truth is that in some cases they do. But not always. In this column I’ll take a careful look at the pros and cons of both types of workplace retirement savings plans, and you should prepare to be surprised: In many ways the group RRSPs and defined contribution (DC) plans which are usually regarded as the poor cousins of the traditional defined benefit (DB) pensions actually come out ahead.

The truth is defined contribution plans and group RRSPs often don’t get the credit they deserve (for an explanation of both, see Which kind of plan do you have?). They’re what most medium and large sized companies provide to help their employees save for retirement these days, although they’re much rarer among small companies. If you have one, it tends to work steadily in the background, slowly but surely compounding savings from the early years of your career when retirement might be the furthest thing from your mind. While the employer contribution by itself is not intended to generate all the savings you’ll need for retirement, if you make modest but consistent contributions over a long time, your savings will grow to a surprisingly large sum. It helps that these plans usually offer a menu of sound investment fund choices at low fees managed by top-notch money managers.

How much of your retirement will defined benefit and group RRSP plans typically support? Obviously individual situations will vary widely. But if you’re a typical couple and each of you earned average salaries over a long career and retired at age 65, then your plan might provide somewhere around half of the savings you’ll need. Employers often contribute up to 4% to 5% to these plans, usually based on matching your contributions. “If your employer is contributing 5% and you’re matching it, then you have 10% of your pay going into savings.” says Brian FitzGerald, co-author of the Pension Puzzle and actuary with Capital G Consulting. “That, plus Canada Pension Plan (CPP) and Old Age Security (OAS), for a lot of people is going to be just fine.” If your employer doesn’t provide retirement benefits then you can achieve the same result by saving the full 10% on your own.

Here’s how the numbers might work. We’ve found that a typical middle-class couple’s retirement costs about $40,000 to $60,000 a year in today’s dollars. Assuming you and your spouse stand to get about $30,000 a year combined from CPP and OAS starting at age 65, then you will need to tap your personal and workplace savings to cover another $10,000 to $30,000 in annual spending. How much will you need to save to achieve that? To safely provide annual withdrawals of $10,000 to $30,000 from your nest egg starting at age 65, research shows you’ll need to save up about 25 times that amount, or $250,000 to $750,000. If you and your spouse currently earn $50,000 a year each in today’s dollars, and over a long career you each save 10% of your pay every year, then your nest egg should end up somewhere around the middle of that range. While no one can predict precisely how your investments will do, those 10% contributions should accumulate to about $500,000 in today’s dollars after 31 years as long as you’re able to achieve a conservative inflation-adjusted annual return of 3%. If things work out well, you might be able to retire a few years early or enjoy a more sumptuous retirement. If they don’t work so well, you might have to save more or reduce retirement expectations a bit.

Of course with both defined contribution and group RRSP plans, the ultimate responsibility for managing your investments lie with you. But your employer helps out more than you probably realize. Michelle Loder, a pension expert with human resource consultant Towers Watson, says sponsoring employers have a fiduciary duty to look after their employees’ best interests when they are administering these plans. They tend to offer a good choice of funds and they carefully choose reputable institutional money managers. Because your employer is pooling money from across its employee base, the plan will almost always pay much lower management fees than you are likely to get on your own. Often (but not always) this will result in you paying investment fees well under 1% of assets, compared to the 2% or more you would pay on regular bond and equity mutual funds you purchase through your bank or adviser.

There has been a lot in the news lately about employers dropping defined benefit plans with their guaranteed payments, and switching to defined contribution plans and group RRSPs. After all, many corporations were burned badly having to cover plan losses during the market crash. You might assume that because corporations find such plans cheaper to manage, you’re going to lose out from this trend somehow, but in some cases, you’ll actually be better off.

That’s certainly true if you work for a number of different employers through your career and you’re moderately comfortable making your own investment decisions. With defined contribution plans and group RRSPs, the money is yours. The money still belongs to you when you move from employer to employer and the value of your investments continues to grow. You have control over your investments and can choose the balance between risk and reward that best suits you. In contrast, when you leave a company offering a typical private sector defined benefit plan, the value of the pension you earned early in your career can become “frozen” based on the salary you earned at the time. And unless the pension is indexed, there will be no subsequent adjustment for inflation or investment returns. “In the defined benefit plan if you pack up at age 40 and go to another employer you usually lose,” says Malcolm Hamilton, a partner with Mercer Human Resource Consulting. “In a defined contribution plan or group RRSP, you just take your money with you. When investments do well, you do well, but you do have to bear the risk.”

Make no mistake, these plans can be a huge help in meeting your retirement goals. That’s why it’s a shame that perhaps only 40% of private sector employees belong to any kind of pension plan or group RRSP at all, according to estimates by Ottawa-based pension consultant Bob Baldwin. But if you don’t have a plan, don’t despair. Many employers take the view that they will pay you as competitive a salary as possible and then let you decide how to allocate it between spending and retirement savings. So you can always choose to save the equivalent amount in RRSPs on your own. “The bottom line is there’s nothing that disadvantages anyone that doesn’t have a pension plan if they have the necessary self-discipline to manage their finances properly,” Hamilton says.