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portfolio strategy

Every last point in financial planning and investing can be debated and dissected, but the desirability of a defined benefit pension is something that unites almost everyone.

DB pensions are offered in few workplaces outside government these days, which means that most people are responsible for their own retirement savings. This brings us to the idea of building your own pension.

A quick take on how DB pensions work, and why people love them: A formula based on your earnings and years of service is used to provide a monthly stream of retirement income for as long as you live. The pension fund managers worry about financial market ups and downs, not you.

The build-your-own-pension (BYOP) retirement lacks the guarantees of an actual DB pension. But in following the blueprint while working and earning, you’ll build retirement savings that could in theory provide a similar cash-for-life experience. If nothing else, the numbers you’ll find below give you an idea of the financial commitment and discipline needed to build pension-like retirement savings.

The biggest BYOP consideration is how much to invest, rather than what to invest in. Brace yourself for the amount required – it reflects the amount individuals contribute to pensions, and employer contributions as well. “I’m going to say it’s eye-popping,” said Michelle Loder, partner at LifeWorks LWRK-T, a wholly owned subsidiary of Telus Corp. T-T, now operating as part of Telus Health.

Let’s look at Ms. Loder’s numbers for 30-, 40- and 50-year-olds who make a salary that will gradually rise to $100,000 at 65, the age of retirement in these examples.

  • The 30-year-old: Investing 16 per cent of gross pay each year would produce an inflation-indexed annual pension equivalent of $43,000.
  • The 40-year-old: Investing 22.1 per cent of gross pay each year would produce an inflation-indexed annual pension equivalent of $34,800.
  • The 50-year-old: Investing 29.3 per cent of gross pay each year would produce an inflation-indexed annual pension equivalent of $23,900.

Ms. Loder used a 2-per-cent accrual rate to determine these pension equivalents, which means the pension payout is based on an averaging of earnings over the years a worker participates in a DB pension. This accrual rate is fairly standard in the DB pension world.

Many defined benefit plans have limited inflation indexing, or none at all. Remove that feature from your BYOP plan and the required savings rates drop to 12.6 per cent for the 30-year-old, 17.3 per cent for the 40-year-old and 23 per cent for the 50-year-old.

Let’s get into some of the other assumptions that underlie these numbers. The first is that you’ll live to 96, which is the age suggested for use by financial planners in their work. Next comes the investment approach, which would be a portfolio that starts at 100 per cent stocks at a young age and then gets more conservative as you age. By retirement at 65, you’d have 40 per cent of the portfolio in stocks and 60 per cent in bonds.

Inflation was estimated at an average 2.07 per cent, which is in line with prepandemic levels and well below the most recent reading of 7 per cent. Ms. Loder said this inflation projection was based on 1,000 different scenarios, and added that the recent surge in the cost of living is expected to be relatively short term.

Returns were estimated at 5.5 per cent on average, a number that came out of the same analysis of 1,000 different outcomes. Fees for investing were estimated at 1 per cent, which suggests a net investment return of 4.5 per cent.

One avenue for building your own pension is to make maximum use of group retirement plans at work, including defined contribution pensions. These plans are about accumulating retirement assets and provide no guaranteed benefit on leaving the work force. Ms. Loder said the fees for investments in group retirement plans are typically lower than regular retail investment costs, which in turn means higher after-fee returns and thus a somewhat lighter savings burden.

A drop in fees to 0.5 per cent from 1 per cent would take the required savings rate for an inflation-indexed pension equivalent down to 14.6 per cent for the 30-year-old, 20.6 per cent for the 40-year-old and 28.2 per cent for the 50-year-old. These contributions would be reduced in a group RRSP/DC pension not only by lower fees, but also by whatever contributions are made by the employer.

A thought on which DIY investments to use for a BYOP plan: Try asset allocation exchange-traded funds, which offer prefab portfolios of stocks and bonds for investors of all risk tolerances. The fees are generally in the 0.2- to 0.25-per-cent range, which is a bargain. Also, some digital brokers allow you to buy ETFs with no brokerage commission costs.

Tax-free savings accounts and registered retirement savings plans are the best BYOP vehicles, but you may find you need to add some money to non-registered investments as well. The RRSP contribution limit is 18 per cent of your earned income to a maximum of $29,210 for 2022. The annual TFSA contribution limit for 2022 is $6,000.

Some final takeaways from these numbers for all retirement savers: Start young where possible and keep fees low. If you’re a latecomer to retirement saving, working past 65 helps a lot.