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How to make your pension work for you
When faced with pension decisions, how do you know what is best for your circumstance? Understanding how your pension benefit works will help you plan for your future.
A pension is simply a source of income that you draw during your retirement. There are two main types of pension plans: Defined Benefit Plans (DB Plans) and Defined Contribution Plans (DC Plans). This article will focus on Defined Benefit Plans.
A Defined Benefit Plan is simply that. At the outset of the plan, the plan sponsor (an employer, government, or union) defines what annual benefit they promise to pay for the duration of your retirement according to a specific formula.
You will accrue, or build up, your retirement benefit according to the plan’s predetermined formula which vary between pension plans. Let’s illustrate this with an example of a common pension formula. For example, your pension statement will probably list some information like:
A common formula for an annual retirement benefit at age 65 = (2%) x (Career Average Salary) x (Years of Service)
The benefit you’ve earned or accrued up until this point is:
Current accrued annual retirement benefit at age 65 = (2%) x ($55,000) x 10 = $11,000/year OR $917/month
Your accrued benefit has already been promised. Even if you didn’t work another day at the company, this benefit would be owed to you.
The statement may also show a projection of what your benefit would be if you continued to work until 65 receiving regular salary increases.
Estimated annual benefit at age 65 = (2%) x ($66,928) x 30 = $40,157/year OR $3,346/month
The defined benefit amount would be adjusted for early or late retirement. Your pension plan administrator can provide estimates of your pension values at specific retirement dates.
Generally, you will have the option to take out your retirement as a lump sum benefit payment (called a commuted value) if you are under the age of 55.
The lump sum payment is calculated so that if you invested the money personally, you would be able to fund an equivalent retirement benefit for yourself. A large portion of this lump sum is required to be transferred into a locked-in account with withdrawal restrictions so that the money is earmarked for retirement. The remainder will have to be received in cash and taxed as income which can create a high tax bill for the year it is received.
Once the retirement date is known, the plan will calculate your retirement benefit based on the plan’s defined formula, and you will be offered different options for payout. Reviewing payout options can be overwhelming but it’s important to remember that these options are calculated to be actuarially equivalent, meaning statistically they would cost the same. Deciding on the best option will be unique to your situation. Some common options are as follows:
Life only benefit
Joint and Survivor benefits
All benefits are taxed as income when received. This form of pension income can be split between spouses prior to age 65.
Defined Benefit Pension Plans should be appreciated for what they are – a benefit promised to you based on a defined formula. Whether you find yourself in the accruing stage of your pension or deciding on how to draw your benefit, a financial planner can help bring clarity and help you to make decisions that work best for your specific circumstance taking into context your entire financial world.
Connect Wealth is an independent financial planning firm that offers holistic advice to clients based on their current goals and future aspirations. We use well-established workflows and cutting-edge technology to maximize planning efficiencies while simplifying the process for clients. Learn how you can maximize your financial opportunities at www.connectwealth.com