Should I Consider Buying Into a Group Pension?

Self-employed incorporated business owners have multiple pension options when planning for their retirement. Using an RRSP or an individual pension plan (IPP) allows tax-deferred and sheltered investing. There are also group pensions that you can buy into, such as a multi-employer pension plan (MEPP). Last week, I described how MEPP pensions work and provided some details about Medicus^(TM) versus HOOPP. I even tried to quantify the cost on a general level. However, when considering whether one of these pension products suits you, it is not just about cost. Your other investing options, psychology, and preferences factor in. So does your overall retirement plan. I would ask myself a few core questions.

Predictable Income & Spending

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How strongly do I prefer predictable income vs variable income?

A more predictable retirement income is what a pension is for. Preference for a stable income would push you more toward a pension. Many people also find it easier to spend money that hits their account regularly than to sell investments to “make their income”. Not only does income smoothing reduce taxes during your working years, it feels more stable. The psychological comfort from a regular income stream also applies to retirement.

Alternatively, you could use variable spending based on market fluctuations. Spending more when markets are on a tear and tightening your belt in a downturn. However, it may not be as easy to do that as you’d think. Those who can safely spend extra when markets do well got there because they save and invest. Flipping the switch from saving to spending is hard. Those who may need to tighten their belts because they have not saved as much may struggle with that when the time comes. We adapt to our lifestyle. Having a smooth stable income base may help someone to plan and spend more comfortably.

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How much variability in spending can I tolerate?

In full retirement, if you cannot simply work and earn income in a down-year. You either draw from your portfolio, leaving less to ride the markets back up, and/or you reduce spending. Reducing spending and delaying some of your consumption may feel different later in life than it did in your youth. Sleeping in a soft bed rather than tent camping sure does.

Time also becomes more valuable when you have less of it. When you are in your retirement years, do you really want to put off trips or other spending until you are even older if there is a market downturn? A delay might easily become a deletion as your health becomes less certain – an unavoidable fact of aging.

Consider what spending level you require to meet your basic needs, as well as “wants” that are important to you and time-sensitive. Understanding your minimum needs and important wants versus your stretch goals and flexible desires is vital to the pension decision.

Group Pension Opportunity Cost

Most people like a steady income, and they also spend more confidently knowing that they have it. However, for self-employed retirees, that comes at a cost. An annuity would provide a guaranteed income stream but is very expensive. In contrast to an annuity, a pension is not a contractual guarantee. There is some uncertainty for pension income depending on its performance, but the cost is also less than an annuity for the target income stream.

If you can tolerate more risk and variability, the alternatives to an MEPP (like an IPP or an RRSP) may offer better wealth generation on average. So, there may be an opportunity cost of choosing a MEPP instead. Consider the risk, cost, and benefits of the MEPP you are considering versus the strategy you would otherwise use. That requires you to consider several questions about your risk and return as an investor.

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Do I prefer to manage my investments, have an advisor do it, or have a pension plan do it?

Investment returns depend on you investing regularly, keeping costs low, and being disciplined. You may be able to do that and would prefer to do it yourself to minimize fee-drag. Alternatively, you may prefer to have an advisor do it. Either way, most high-income professionals or business owners use some combination of those options.

We have multiple accounts to use, like TFSAs and/or a corporation. A pension manager doesn’t help with those, and if you are comfortable using those accounts already, you might prefer an RRSP or IPP instead. They give you more control, flexibility, and potentially more wealth generation. I say “potentially” because it depends on your costs and execution.

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How aggressive and consistent of an investor am I?

It is important to consider how you are as an investor. Making higher returns than a pension, despite the higher costs than DIY, or the pension’s requirement to cover some of its liabilities with lower-returning fixed income, is not a sure thing.

You must consider your risk tolerance and asset allocation. If you are an extremely conservative investor, having your investment risk hidden from you and pooled within a pension may be preferable. A pension with a higher risk/return investment strategy than your baseline is attractive. You probably answered the stable income questions favoring a pension as well.

Your investment returns may also be aided by investing with a good advisor. Not because they stock-pick or market-time. There are good reasons why using an advisor doesn’t help you beat the market. Rather, it is because they prevent you from doing those things. The education and support here or on Facebook may be enough for some investors and are free. However, for those who require more, advisor support may enable them to invest more consistently and tolerate a higher equity allocation than they otherwise would. If you are using an advisor with high costs who doesn’t enable better results, then a pension may be more attractive.

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What is the likelihood of a shortfall versus the cost of mitigating that?

Buying into a pension comes at a cost. You gain predictable income and spending ability. However, the trade-off is that the money could have been invested using an IPP or RRSP instead. Those vehicles have more uncertainty because you have the investment risk. Rather than sharing it with a group. However, if you invest effectively as a DIY investor, or use an advisor who provides value, that higher investment risk should be compensated with a higher return.

That is “on average”. You may have a strong chance of having more money to spend or give, but a small chance of having less. There is more variability in outcome. Quantifying the opportunity cost of using the pension versus the probable outcomes of alternatives forms part of the decision. It is complex and one of the areas where a professional financial plan supplements DIY investing.

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Will I likely have more than enough at retirement, or will I be close to my minimum needs?

It is much easier to accept taking some risk in the pursuit of more wealth generation if the risk of you having a catastrophically bad outcome is minuscule. This depends on the cost of your retirement relative to the size of your portfolio. The cost of retirement includes your basic needs and important wants. The more you plan to spend, the more you need. The cost is also determined by the duration of your retirement. If you retire early or have Yoda-like genetics, then you need a larger portfolio.

If you have so much money in your various accounts that there is an extremely low risk of not meeting your basic needs as the floor. Coupled with a high probability of generating more meaningful wealth to enjoy while alive, putting money into a pension may not be attractive. In contrast, if your portfolio is going to be close to the size needed to fund your retirement and vulnerable to some unlucky market returns or longevity risk. Then, mitigating those risks using a pension would be very attractive.

Where Do Your Lie on the Spectrum?

For some, the decision between using an MEPP vs an RRSP or IPP will be obvious. However, most of us have a jumble of competing preferences and circumstances. So, I made this preference scale visual aid to help get it out onto paper. You may then have a clear answer, or perhaps a partial one. That is okay, because a pension doesn’t need to be an all or nothing decision and it can also be made at different points in time as I will come to in the next sections.

How much do I want to pensionize?

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How much “insurance” do I need?

A pension does not need to be all or nothing. It should be the right amount to serve a purpose. You can think of it kind of like “insurance” for a basic spending requirement in retirement. You pay a premium to shift the risk of something rare, but catastrophic, to the “insurance company”.

In the case of retirement income, falling short of the money required to meet your minimum lifestyle requirements (minus the nice-to-haves) would be catastrophic. It would hopefully be rare, but that depends on the size and growth of your portfolio. We do get some government-mandated coverage through the Canada Pension Plan and Old Age Security. However, that likely falls short of your basic needs. Paying into a group pension to “insure” that gap may be attractive. The larger the shortfall and the more likely your portfolio is to not cover it, the more attractive an MEPP becomes.

Like with insurance, the provider prices are based on the liability – so you don’t win by buying coverage you don’t need. Similar to insurance companies, pension providers will also encourage you to buy the most that you can, as soon as you can. However, you want to buy the right amount relative to your other options.

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Does a pension enable me to take more risks elsewhere?

It is also important to consider how a pension fits in with the rest of your investments. For example, knowing that your basic income needs are met enables you to take on more investment risk elsewhere, which may improve your probable outcomes.

A high equity allocation in your investment portfolio maximizes the chance of wealth generation and is also the most likely way to maintain your buying power over decades. The historically optimal asset allocation is all-equity. However, in practice, that is extremely difficult for investors to tolerate.

A pension offers a stable platform, and it is easier to tolerate short-term market volatility when you know your basic needs are met. If a pension can replace some fixed-income in your portfolio, it may help your overall returns.

When should I contribute to a pension?

If the amount of future benefit that you want to buy is not going to consume all of your pension or RRSP contribution room, then the question is, when should you start buying that benefit? You want to contribute over a long enough timeframe to get the benefit you require. If you are behind, you can also “buy back” previous service and transfer funds (usually from your RRSP) into the pension. The cost for doing that depends on your RRSP size, years of service to your corporation, and salary paid.

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Benefit Increase Rate vs Your Investment Returns

Depending on how you would otherwise invest the money, there may be an opportunity cost to contributing early. If your regular investing is likely to have a much higher rate of return than the rate at which pension benefits increase, then there is an opportunity cost to having it invested for longer in the pension.

For example, the HOOPP benefit that you buy each year while working increases into the future. During working years, it increases by the yearly maximum pensionable earnings (YMPE) increase. The government increases the YMPE each year. Historically (1990-2022), the YMPE increased by 2.56%/yr CAGR. Inflation averaged 2.01%/yr CAGR during that time. So, the YMPE increased by ~0.55%/yr above inflation.

So, the future pension benefit that you buy today may be expected to increase by inflation plus 0.55%/yr. In contrast, bonds have historically returned roughly inflation plus 1%/yr. Global equities have returned roughly inflation plus 5%/yr on the whole. That is what you would expect, given that equity investing is higher risk than bonds or the pension. US equities have returned about 7%/yr over the past century. Whether the US is special due to its geography and capital markets or whether it has been lucky is uncertain. If you are willing and able to take investment risk on your own, then a group pension has an opportunity cost.

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Starting Early vs Late

If there is an opportunity cost compared to how you would otherwise invest, the longer you invest via the pension, the higher that cost is. For example, if you require 10 years of your pension contributions to get the benefit you want, buying those 10 years towards the end of your career would minimize that opportunity cost compared to buying them at the beginning of your career. The difference could be profound due to the effect of time on compound returns.

For example, let’s say that you want 10 years of your income pensioned to give you a secure “income-floor.” The rest of your investments are going to be in an RRSP. Assume that you can handle a high equity allocation and use low-cost index funds to achieve a real return of 5%/yr over the long run. Incidentally, that is easier to do when you start young and have a longer timeframe. If you contribute to your RRSP first, you could have a large RRSP earlier, and that means a large difference later due to the power of compounding. If you contribute to your pension first, those 10 years at 5%/yr could mean a 40% smaller RRSP at year 40 due to the late start. The pension benefit would grow more due to the extra 10 years, but that only translates into a marginally larger benefit due to its slower growth rate. I hope to model that further in a future post.