If You Could Buy A Gold-Plated Government Pension, Would You?

by Mike Holman

Workers who don’t have access to a defined benefit pension are often quite jealous of workers who do. We wish we had something similar, so that we wouldn’t have to worry about our retirement income.

A defined benefit pension is where a worker makes regular mandatory contributions during their working career and then receives a guaranteed paycheque in retirement.

Annuities are a pretty good solution for people who want a defined-benefit-like income stream in retirement. Moshe Milevsky and Alexandra MacQueen took a detailed look at how to incorporate annuities into your retirement plan in their excellent book – Pensionize Your Nest Egg.

But for some reason, annuities aren’t very popular. There are many retirees who would benefit from converting some or all of their retirement portfolio into annuities, but most don’t.

An annuity is an insurance product where you pay an upfront fee in exchange for guaranteed payouts until you die.

The mystery of why more seniors don’t buy annuities is referred to as the annuity puzzle.

Why people don’t like annuities

The problem is that people who have been saving money for a long time and have accrued a nice little nest egg, have a hard time handing over a big chunk of cash for an uncertain return. What if they die two weeks after buying the annuity? What if their investments get really good returns after they convert them into an annuity? What if they change their mind? (annuities can’t be “unbought”).

Another issue is lack of knowledge – not many retirees know what an annuity is or how they work.

Some people don’t like annuities because they usually don’t payout any money to their heirs.

Buying an annuity is too difficult a decision for most people and that’s why most Canadians that should buy some annuities, don’t.

Why do people with defined benefit pensions not have the same issues?

On the flip side – someone who works for an institution that offers a good defined benefit plan gets used to the idea from the very beginning of their career that they are making contributions in exchange for a future income stream in retirement. They don’t have to worry about making a wrong decision about their life expectancy, because there is no decision to make.

Leaving their “pension pot” to heirs is not a decision that someone with a defined benefit plan has to deal with, because in most cases it won’t happen.  It’s not uncommon for a spouse to be eligible for a reduced survivor’s pension, but once that surviving spouse dies, the pension dies with them.

Unless their defined benefit plan contains a survivor’s benefit, they have no concern that those contributions won’t be able to be passed on to the next generation.

Another factor is that defined benefit workers are buying their future income stream one paycheck at a time in small palatable dollar amounts.  Buying a pension with an $800 deduction from your paycheque each month is psychologically a heck of a lot easier than buying the equivalent annuity at age 65 for $650,000.

Most people with defined benefit plans don’t have an appreciation of the amount of money their pension is worth. It’s not uncommon for a retiring government employee to have a pension “pot” that is worth between one and two million dollars. But that employee never sees that money total in an account. They just see their retirement income stream in the form of cash payments once or twice a month. Perhaps they get $45,000 per year from their pension. Most retirees don’t equate their pension money with a large nest egg, so the thought of losing that money if they die early isn’t really a problem for them.

How to solve the annuity puzzle?

More knowledge about annuities would help. People without defined benefit pension plans have to understand that defined benefit pensions and annuities means no inheritance for that money. You can’t have your cake and eat it too.

Retirees have to learn that in order to get a decent guaranteed income stream, you have to fork out a lot of money.

If a retiree wants to leave money after their death, they have the option of only converting some of their money into annuities.  The remainder can stay invested in traditional investments and will be available to be passed on when the retiree dies.

There aren’t really a lot of differences between a defined benefit plan and an annuity. If you could buy an annuity starting at an early age (ie with monthly contributions) that doesn’t pay out until you are 65 (or some agreed upon age), then guess what – you have a defined benefit plan. In reality an individually purchased annuity will likely cost more than a defined benefit plan, but on the other hand – a person who saves their retirement money in an RRSP has more flexibility in terms of when they buy an annuity and what percent of the portfolio they convert to an annuity. They can also buy multiple annuities over time.

Conclusion

We tend to look at the good parts of defined benefit pensions and ignore the bad parts.  Kind of like admiring your neighbours lawn and wishing your lawn looked as green as his, but ignoring the fact that he spends three hours every weekend working on it.

If you have a decent-sized retirement portfolio and no guaranteed pension, annuities likely should be part of your investment plan.

Do you know anything about annuities? Would you consider them for your retirement plan?

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{ 22 comments… read them below or add one }

1 C Power

In your article above, should there be the words “does not” before the word “contains”? See paragraph below:

“Unless their defined benefit plan contains a survivor’s benefit, they have no concern that those contributions won’t be able to be passed on to the next generation.

2 Sustainable PF

My Dad, who has a university “gold plated pension” has coupled that pension with annuities from his and his wife’s savings/investments. Now, he wasn’t a tenured professor until his mid 40s and retired around 60 – I should ask him why they went this route. Likely security.

3 Mike Holman

@C Power – No. I rewrote that sentence, since it wasn’t worded very well. Not sure if it’s any better now. :)

@SPF – That seems like overkill, but maybe he just wanted the simplicity?

4 Vickie

I don’t think I would buy a Gold Plated Pension!!!!!! The only pension is the pension of my LORD!!! You can’t take anything with you when you go, so just use what GOD has supplied you with on earth and be happy with what he gives you, That’s if you Believe in his Word. Thank You and Have A Blessed Day!!!!!

5 mred

The reason people dont want annuities is because theyre not only locked in at a fixed price but also a life term with NO survivor benefits and no chance of redeeming them after a certain period of time.

Its a legalizd scam by insurance companies because when an annuitant dies with say $500.000.00 in his annuity after say five to ten years what does his wife get ?/ zilch, nada, nothing . ne rien, nichts.

In all cases I would say unless you know youre going to live to be 100+ the stock market and government bonds are your best bet in a RRIF.Then you may ? out live your original principal but I doubt it as I believe all the insurance companies give you is the interest on the capital and when you die they keep the original capital ..As Homer Simpson would say dddddoooooooooo

At least with a RRIF your wife gets the RRIF tax free.(by operation of law)And when she dies the heirs get the balance after taxes.

Whats so hard to understand about that compared to an annuity?

I have seen the stock market go up and down like a whores drawers at a convention ,over the last 65 years, that I have been in it, and it ALWAYS WINDS UP HIGHER AFTER A FALL.

Whereas unless someone invested in an annuity when there was double digit interest rates in the `70`s they would have lost their money.

And with todays interest rates at historical lows what kind of return could you get on an annuity ?

If you want people to invest in annuities you have to make them user friendly not insurance company rip-offs.

6 Echo

“If you could buy an annuity starting at an early age (ie with monthly contributions) that doesn’t pay out until you are 65 (or some agreed upon age), then guess what – you have a defined benefit plan.”

Isn’t that called CPP?

7 Mike Holman

@Echo – Yes, the CPP (Canada Pension Plan) is a defined benefit pension plan. However, it’s a bit limited. :)

8 Jim Yih

Great article Mike! Now you need a tweet button so I can share it with everyone.

9 Mike Holman

Thanks Jim. I tried adding a tweet button once, but I couldn’t get it to work. I should give Tom a call. :)

10 Mark M

Buying an annuity (guaranteeing a certain payout) seems like a better deal when interest rates are high. (I appreciate that when interest rates are high, there are other low-risk ways of buying guaranteed income. But there is less sticker shock.

11 stu

Any annuities I’ve checked out give a very low return, guaranteed for sure but still low. I’ll keep my money in dividend stock portfolios till I see something better. As always insurance companies never do anything out of the goodness of their hearts (what hearts?) so someone must be getting screwed.

12 My Own Advisor

Good post Mike.

I think folks need to remember that many people who contribute to DB pensions (like me), hand over about 6% of their salary. My DB pension is largely invested in indexed products, and there is absolutely nothing preventing folks who do not have a DB pension, to invest their 6% in indexed products as well.

I think the big fear folks have with an annuity, there is no recourse after they are purchased. Lack of knowledge is another barrier, but the same can be said for mutual fund fees. :)

I agree with you, if folks are lucky enough to have decent-sized retirement portfolio and no pension whatsoever, annuities likely should part of the equation.

13 Mike Holman

@Mark – Good point.

@MOA – I don’t know about your pension, but a lot of pension plans have contributions from the employer (ie government) as well. Ie if an employee is contributing 6% and the employer is contributing 6%, a non-DB pension worker would have to contribute 12%.

14 lee R

Check out Manulife products I thought they offered a variety of annuities which can allow (for a cost) survivors benefits and/or monies to pass along to the estate. I am retiring in a few years with a OMERS pension and will have a portion of my investments allocated to annuities. I like the comfort in my retirement of knowing what my guaranteed income will be. I am hoping to be able to draw income from a number of sources (pension, annuities, RRSP, TTSA, and dividends from investments, and govenrment benefits CPP OAS. Pensionize your nest egg is a must read for anyone nearing retirement or for that matter anyone at any age who needs to plan for retirement cheers

15 Zerodown

A key issue with annuities is credit risk. An insurance company is not the government of Canada or a province. Long dated insurance bonds come with 200+ basis points of spread for a reason. If the Feds wanted to nudge people toward annuities they would create a CDIC for annuities. Currently plan members are just equal in seniority with with senior bondholders (as I understand).

CPP and all other plans are naturally invested in balanced portfolios that one might replicate, the difference is the guarantee! Even if that portfolio tanks, the CPP (or OMERS or corporate or whatever) will add more cash from current operations and “active” plan members. An individual doesn’t have this option (unless you have lots of generous kids).

16 Mike L

I have an anuuity as ONE of the sources of my retirement income,.There seems to be a lot of misinformation in these repilies.

Mred–there is CIDC like insurance for anuities, It insures your payments up to a max of 2000 dollars a month. If you want 4000 a month from your annuities , then you buy two 2000 dollar ones, each from a different company, and both are covered.

A husband and wife can buy a Joint Annuity. It pays out the full amount until both spouses die.

Annuities are less affected by current interest rates then one would think. Longevity tables, that is the age you start receiving the pay outs , have a much greater impact on the pay outs than the current interest rates at the time you buy the anuuity.

The book “Pensionize your Nest Egg”explains all this well. It recommends that you use your nest egg to buy a mix of sources for you retirement income—example; anuities, RIFFS, a portifolio of non-registerd securities such as dividend stocks , bonds and REITS. Basically, don’t put your nest egg in one basket.Reading the book might help decide what mix is best for you.

17 bubak

You can see ads with mortgage rates on TV, billboards, buses, but nobody knows what the going rates are for an annuity.

18 Mike Holman

@lee – Most Manulife products are pretty expensive.

@Zerodown – True, an annuity is not as safe as a government pension. It’s probably more safe than a company pension however, mind you those are pretty rare these days.

@Mike – Thanks for the info.

@bubak – Very true – basic annuities don’t pay much or any commissions so they don’t get “sold” like most commissioned financial products.

19 Eclectic Investor

@Mike: Generally a good article.

IMO, it overlooks the *most* important reason why someone in a DB plan doesn’t have the same issues. Specifically – they don’t have a choice.
The only way I’ve been offered to avoid a DB pension is to quit the job or become a part-time worker.

Only those with a choice will be concerned with the pros/cons, dying young etc.

It’s like the DB versus DC pension presentation I attended that was mandated by a previous employer. The employer was encouraging the DB pension members to convert to a DC pension. A lot of the information was interesting (ex. factors to consider, pros versus cons) but irrelevant. At the end of the day, for my job level, the choice was a DB pension versus no pension.

Cheers

20 Mike Holman

@Eclectic – Yes, that’s a good point as well.

21 Paula @ Afford Anything

I would never buy an annuity that is sold/managed by a private company. What happens if the annuity company goes broke or defaults on its payments? You’d be just another one of thousands of its creditors …

22 Yolanda

Hello Mike

I just found your blog today and it’s going to take a while to go through all of this good information!

Could you please clarify something that you wrote in this blog post? You said:

“Buying a pension with an $800 deduction from your paycheque each month is psychologically a heck of a lot easier”

I’m not sure if you are in a DB pension, but I make nearly $100,000 and my contribution is 5% or roughly under $200/pay.

Is your $800 figure correct or am I misunderstanding something?

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