Should you buy back pension service from your employer?
While defined benefit (DB) pensions are the Cadillac of retirement plans, they also entail a unique set of decisions. Buybacks are one of them.
There are a few ways to build up the value of your DB pension: by working to accumulate years of “pensionable service,” of course; by transferring service you earned from a previous job to your current plan upon retirement; and through buybacks, which are basically what they sound like—you purchase periods of service to add to the total years used to calculate the value of your DB pension.
DB pensions provide a fixed future income base based on a formula for final/highest average earnings and an interest rate for accumulated years of service. According to Matthew Ardrey, vice-president of Toronto-based TriDelta Financial, a pension buyback affects the years of service part of that formula. Each year you earn, or buy back, has a multiplier effect on the overall pension. “[It’s] evident why someone may want to do the buyback,” says Ardrey, “as pension plans reward employees with longer service.”
When you consider the annuity-like, guaranteed-for-life nature of DB plans, plus their relative immunity from stock market volatility (often with inflation indexing), the opportunity to buy back service is compelling for many.
You will need cash for a buyback, or you can tap RRSPs, or both. If cash, you must have available RRSP contribution room this year. Buybacks fall under the Past Service Pension Adjustment calculation, or PSPA. The PSPA reduces your RRSP contribution room in the current year, and Ottawa permits an $8,000 contribution beyond your RRSP room. Thus, the value of your buyback may be greater than your RRSP room once you consider employer contributions and future benefits.
Topping Ardrey’s list of buyback “pros” is a bigger pension at retirement. Since pensions reward longer service, buybacks let you buy more past service, and the deal is sweeter still if your employer matches contributions. But the later you wait, the costlier a buyback will be. The commuted value of the pension becomes larger the closer to when those payments are being made, Ardrey says.
Longevity can be a pro or a con, depending on when you die. The longer you live, the more attractive the pension becomes and, with it, the value of a buyback. Cost is another consideration, especially in today’s market. Cost comes down to how much commuted value is needed to purchase in order to receive a year of pension benefits. Because interest rates are so low, buybacks are more expensive than they would be at more normal levels. “All else being equal, the higher the interest rate, the lower the commuted value,” Ardrey says. “With interest rates being at all-time lows, this is perhaps the worst timing you can have for making the pension buyback.”
Those who will rely on investments in taxable or registered accounts to fund buybacks will find it more expensive if they must sell securities beaten down by the COVID-19 crisis. “It is a double whammy of higher commuted value and lower asset values that makes this the wrong timing for this purchase,” Ardrey says. Ideally, wait until after December 1, 2020; by then, there may be changes to how the commuted value is calculated.