Defined Benefit pension plans are not as common today as they used to be. Unlike a Defined Contribution pension plan, with Defined Benefit the sponsoring company guarantees its employees a certain level of retirement income regardless of the investment performance of the contributed money. In other words, the company assumes the investment risk, while with Defined Contribution plans this risk falls entirely on the employee. Very few companies in Canada still have Defined benefit plans, with a few exceptions. Nobody likes to carry the investment risk unless it is absolutely required. You can hardly get such a plan today, but there are still many of them out there.

A planning strategy commonly known as Pension Maximization used to be popular just a few years ago. This is how it works. When an employee retires, he or she has a couple of options: a single life pension or a joint pension. With single life pension the annuitant receives guaranteed income for life, but after the annuitant’s death the surviving spouse gets nothing. In contrast, a joint pension will provide a certain percentage, typically around 60%, to the surviving spouse. Obviously, the joint option pays lower income to the annuitant.

With the Pension Maximization strategy, the annuitant opts for the single life option, but the difference between the single and the joint option is used to fund a life insurance policy, rather than simply spent. When the annuitant dies, the life insurance proceeds are used to purchase an annuity on the life of the surviving spouse, and that annuity will provide higher income to the surviving spouse than the survivor pension would. Alternatively, an insurance policy can be purchased to provide just enough income to match the survivor pension. In this case the couple has more disposable income while both are alive and the same income after the main annuitant passes away. The pension income is “maximized”.

Unfortunately, if you try to do it now, you will discover that it won’t work. The income from the annuity will be significantly lower than the survivor pension most Defined Benefit plans provide. The reason is that in those plans income is based on the interest rate assumption made at the time when the plans were designed, while an annuity pays income based on today’s actual interest rates. If you have a benefit plan designed in the 80’s when the interest rates were in the double digits, there is just no way you can beat such a plan by purchasing an annuity today, since the rate of return in most annuity contracts today is close to zero. Nevertheless, Pension Maximization is a brilliant strategy and one day it may be popular again. You just need to wait for the interest rates to go back up to the double digit area.

Nikolay Sisan is a Certified Financial Planner and freelance writer in Vancouver.