WHAT IS Past Service
Past service refers to the period of employment prior to an employee’s participation in a pension plan. That period may exclude the employee from certain benefits that existed prior to their participation in the plan. Employees have the option to purchase past service, using cash or through a qualified retirement plan roll-over, to increase their years of service in the calculation of their retirement pension. In a defined benefit plan, the employer has the option of funding for past service or not.
BREAKING DOWN Past Service
Purchasing past service involves paying a fixed amount of money in exchange for prior periods of missed pensionable service. Purchasing past service may help maximize retirement income and provide additional financial security, particularly if an employee took a leave of absence from their job at some point in their career. Some common reasons for leaves include time off to raise a family, go back to school or to travel. Deferring participation in a pension plan may be another reason to purchase past service.
Most retirement pensions for defined-benefit pension plans are calculated according to a formula similar to:
- Retirement pension = (number of years of pensionable service ) multiplied by (a certain percentage for each year of service ) multiplied by (average of final or best earnings over a 3-5 year period)
Notably, this type of transaction is irreversible. That makes understanding the cost-benefit dynamics before making the transaction critical. This involves calculating whether or not the expected incremental retirement benefit to be received as a result of the past service purchase exceeds the foregone retirement income that could have been produced with the money used to purchase the past service. It is important to review how the past service purchase will affect an individual’s overall financial plan.
Paying for Past Service
There are several ways to pay for a past service purchase. Funds held in a registered retirement savings plan (RRSP) can be used to pay for past service. In this case, a direct tax sheltered transfer from RRSP account to the pension plan can be made. If the RRSP does not have sufficient liquid assets, a lump sum contribution can be made to the RRSP to make up the difference. It may also be possible to pay for past service by transferring funds from a former pension plan, provided the current pension plan provider is willing to accept the funds. Lump sum contribution or installment contributions with non-registered funds, including payroll deductions, can be made as well.
In cases where employees are considering rolling over the assets from their qualified retirement plan, it is often wise to first consult a financial planner.