Earlier I had written about how we are planning a pension buy-back for my wife after she goes back to work from a maternity leave.
For those who aren’t aware, a pension buy-back is basically buying back missed years of service (ie. maternity leave) to ensure that the defined benefit pension isn’t reduced due to the missed time. For those who are able to buy back missed time it can be a great opportunity to ensure their retirement income is kept high.
The short term pain (the cost of the buy back) can translate to long term gain if the increased retirement income from the buy-back is higher than the initial cost.
Factors to Consider
When deciding whether to take a pension buy-back you need to factor in: the opportunity cost of the buy-back, life expectancy and the difference between a full and partial pension.
Example: Janice plans to retire in 10 years. She is currently 55 years old. The cost of a pension buy-back is $50,000 for 3 years of missed service while on maternity leave.
The annual pension income upon retirement WITH the buyback is $60,000. The annual pension income upon retirement WITHOUT the buyback is $57,000.
Janice will take her pension (full or not) when she turns 65. She plans to live until she is 95. If she invested the $50,000 instead, she could earn 7% per year. If she invests the cost instead of using it to buy-back her missed years of service, she will need the money when she retires at 65.
No buy-back: $50,000 reinvested annually at 7% per year for 10 years = $98,000 (approximately)
Buy-back: ($60,000 full pension – $57,000 partial pension) x 30 years of retirement = $90,000
Conclusion: In this case, it makes sense for Janice to invest the $50,000 instead of buying-back her past years of missed service.
Note – Keep in mind that this example is meant to be simplistic (illustrative only) and all other factors have not been taken into account. Each individual situation is different. When determining whether a buy-back makes sense for you, make sure you seek financial advice before making your decision.
In our case it would likely make sense for us to buy-back her missed years of service so that she can have a full pension (or close to it) when she retires.
When my wife retires she will have over 30 years of service, we expect the cost to be reasonable (and will set aside money before so we can afford it) and she is ideally looking for low-risk, guaranteed income that her pension can provide.
Is a Pension Buy-Back Right For You?
|Description||When a Buy Back Makes Sense||When a Buy Back Does NOT Make Sense|
|Length of service with employer||Longer term of service||Shorter term of service|
|Estate planning||No children (pension plans give income to spouse)||Children (RRSP gets transferred to estate)|
|Need for liquidity/flexibility||Low need for liquidity (pensions are more restrictive)||Higher need for liquidity (RRSPs are more flexible)|
|Time||Short amount of time has passed since missed years of service||Long amount of time has passed since missed years of service|
|Life expectancy||Longer life expectancy||Shorter life expectancy|
|Cost||Reasonable (given individual situation)||Prohibitively high|
|Tolerance for risk upon retirement||Low tolerance (pensions provide guaranteed income in retirement)||High tolerance (RRSPs are market-driven)|