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Jun 4, 2019

The Biggest Money Mistake That You Might Not Even Know You’re Making

by Eric Vallee

Eric ValleeWe all would like a little more money in our pockets. Have you ever been sitting at work thinking, “You know, I could use a raise”?

Did you know that you might be able to give yourself a raise, without having to beg your manager for it?

“What kind of sorcery is this?” you ask.

Not doing one simple thing could be costing you tens or even hundreds of thousands of dollars over your lifetime.

The Company Pension

The company pension plan doesn’t mean what it used to. Receiving the average of your five best earning years, adjusted for inflation, for the rest of your life is not a perk that many companies offer anymore. This is something that is typically reserved for long-tenured employees who are grandfathered-in under older pension plans, or for many of our public sector employees (such as teachers).

This type of pension is known as a defined benefit (DB) pension plan. This means that the company will commit to paying you a certain amount based on your years of service. This dying breed of pension plan has historically been the holy grail of retirement for many Canadians.

Nowadays, the typical pension offering from employers is what is known as a defined contribution (DC) plan. The way that these plans typically operate is that a portion of each of your pay cheques is withheld and routed into a group Registered Pension Plan (RPP) savings program. This diverted cash forms the basis of the contributions that you make into the pension plan. These contributions are treated like Registered Retirement Savings Plan (RRSP) contributions for tax purposes, just as if you were to contribute to your personal RRSP accounts. Thus, you get the same tax deferral benefits that you would get from a typical RRSP contribution.

The reason that employers have moved away from DB plans can vary. However, the primary reason is that they typically end up being more expensive than DC plans. The reason they are more expensive comes down to a number of factors. When trying to determine what you will have to pay out in the future for a DB plan, there are several variables. Return on pension assets and life expectancy of pensioners are two primary ones. Naturally, this leads to some unpredictability. The company has to “fund” the DB plan in an attempt to ensure adequate funds are available to pay out the future benefit for the pension plan members. Many plans today are underfunded due to the inherent unpredictability in many of the variables, like our prolonged low-interest rate environment. As such, it leads to companies having to carry significant liabilities on their financial statements, as they are required to “make up the difference” and ensure the plan is adequately funded at some point.

With a DC plan, once the employer funds the plan, the outcome is final. Payment made. End of story. This makes it no surprise that companies have shifted to a cheaper more predictable alternative.

Now the Pension Match Magic Happens

As employers move away from DB plans and shift to DC plans, employers will often offer to contribute to your DC plan on your behalf as well. They typically contribute in 1 of 2 ways:

  • Base pension contribution
  • Pension matching contributions

When you enroll in the DC plan, the company will typically offer a base contribution. This is usually measured as a percentage of your salary. For example, 2.5% of your gross salary from each pay cheque would be paid by your employer into the savings plan. I have seen plans that will offer the base contribution even if you don’t make contributions yourself, but rather just for filling out a form! This means that you would, in essence, get a 2.5% raise just by enrolling in the program. However, some base employer contributions require you to make contributions yourself to participate in the plan.

In addition to the base contributions that a company might make, they will often offer to match the contributions that you make to the plan, up to a certain limit. For example, if you contribute 5% then the company may offer a 2.5% match or even a full 5% for a 1:1 matching of your contributions.

So What Mistake Am I Making? Not taking them up on their offer!

Unfortunately, many employees may not know that their employer offers this type of program. In my experience, this generally is not a perk that is widely advertised in the workplace. I have known co-workers and acquaintances who have worked at a company for ten or more years and were not taking advantage of these programs solely because they didn’t know that they existed.

Luckily, this is easily rectified. When you go into work tomorrow, inquire with HR or look up on your intranet whether your company offers a DC pension match program.

The Catch

When companies give away free money, they tend to have some rules around it

  • Minimum Service Time
    • Often there is a minimum amount of time that you must have been with a company before you can enroll in the program. This can be anywhere from 3 to 12 months in some cases
    • Vesting
      • In some cases, there may be a vesting period applied to the company match portion of the funds contributed to your plan. For example, if your company had a two-year service time vesting period, it would mean that if you left the company prior to your 2-year anniversary, the contributions made by the company would be paid back to the company.
      • Reduction to your contribution room
        • There truly is no such thing as a free lunch. The contributions that your company makes to your DC account will result in a reduction of your RRSP contribution room. This reduction is done through what is known as a Pension Adjustment). This amount is reported on your T4, and the adjustment takes care of itself when you file your taxes each year.
        • Since this has an impact on your contribution room, make sure that you contemplate this when determining your level of participation in the plan (i.e. whether to contribute 3% or 7% of your salary) to ensure that you don’t over contribute. Given that you are entitled to contribute up to 18% of your earned income, up to a maximum of $26,500 in 2019, the RPP contributions alone shouldn’t result in an over-contribution.
        • You should also factor in the RPP contributions that you make to your work plan if you are also going to make an RRSP contribution. It is your responsibility to make sure that you don’t over contribute.

The Benefit

There are a few main benefits here:

  • It’s free money. This is fairly self-explanatory. If you end up with a 1:1 match on your contributions, this effectively means that you just made a 100% return on your money! Not bad for filling out an enrollment form.
  • This acts as a means of forced savings. Saving for retirement can be a challenge for many. A great way to work around this challenge is to save automatically before the cash ends up in your account each payday. You are allowed to contribute up to 18% of your income to your RRSP in any given year, up to a maximum of $26,500 for 2019.
  • The benefit of compounding. Since this all happens automatically in the background after enrollment, the benefits can add up quickly. Let’s use a simple example. Let’s assume the following:
    • $65,000 salary per year.
    • Earn a 2% raise every year.
    • You make a 5% DC contribution.
    • The company has a 2.5% base contribution rate.
    • The company also has a 5%, or 1:1 match on your contributions.
    • You can enroll in the program on your first day at the company.
    • You work at the company for 20 years.
    • Investment income of 5% compounded annually.

At the end of your 20-year tenure, you would have contributed around $79,000. Adding in employer matching and investment growth, you would have roughly $324,000 in your DC account!

Saving for retirement is a critical aspect of your overall financial picture. You may be missing out on a significant tool in your arsenal by not participating in your company pension plan. Pension match contributions are effectively free money and can greatly impact your retirement savings. Inquire with your employer to determine what kind of pension or group savings plan offerings they have, and whether or not they have a pension-matching program.

Over these 20 years, you will have contributed ~$79,000. Your company will have paid you ~$118,000! Combine that with the investment growth over 20 years, and your $79,000 of contributions is now worth over $324,000!

The Brass Tacks

Defined Contribution pension matching programs are one of the best tools to save for your retirement that you may not even know about. By automatically contributing to a savings plan, you will be saving for your retirement without any effort beyond filling out an enrollment form. Give yourself a raise by inquiring with your HR department as to whether your company offers this type of savings program.

 

Eric Vallee, CPA, CA is a fee-only financial planner with Novel Financial Inc. Reach him at eric@novelfinancial.ca