Pensions 101 – The Basics of Defined Benefit and Defined Contribution Pension Plans
The following article is a guest post by Sean Cooper who blogs about personal finance at Sean Cooper Writer.
Are you confused by your workplace pension plan? You’re not alone. Read on to learn about pensions 101 – all the basics related to Defined Benefit (DB) and Defined Contribution (DC) pension plans in today’s primer.
Working as a pension analyst at a global consulting firm for five years has made me realize there’s a knowledge gap when it comes to pensions. I’m going to help close that knowledge gap today – sharing the basics and maybe a bit more about pensions.
The Differences between Defined Benefit and Defined Contribution Pension Plans
There are two main types of pension plans: defined benefit (DB) and defined contribution (DC).
Defined Benefit Pension Plans
With a DB pension, what’s “defined” or known in advance is the income you’ll receive in retirement. Your employer promises to pay you a monthly pension based on a formula that usually includes your annual earnings and the number of years you’ve worked there.
A lot of DB pension plans are contributory where both you and your employer contribute. Your employer invests these contributions into a pension fund to help cover future payouts. In this plan the employer bears the investment risk, as they must make up any shortfall if investments underperform.
DB pension plans make planning for retirement a lot easier for workers; you’ll receive statements about your pension benefits, indicating the monthly pension can expect to receive at your normal retirement date (NRD). Here’s an example of a typical DB pension formula:
Annual or Average Annual Salary x Benefit Percentage x Years of Plan Membership = Annual Pension
$60,000 x 1.5% x 25 = $22,500
Defined Contribution Pension Plans
With a DC pension, what’s “defined” or known in advance is the amount both you and employer contribute each year. The amount you and your employer contribute is based on a percentage of your annual earnings. The contributions are usually between 3 %-6%. Your employer will often match the amount of contributions you make; by not joining this type of pension plan I want to highlight you’re definitely leaving free money on the table.
Unlike a DB pension plan, the funds aren’t invested into a pension fund; instead each employee has their own individual account. With a DC pension plan, the investment risk is on the employee. For this reason, there has been a significant trend towards employers de-risking and switching from DB to DC plans over the years.
The amount of income you’ll receive in retirement depends solely on how well your investments perform over your lifetime in the DC plan. For that reason retirement planning for retirement is more difficult with a DC pension plan. Think of it this way, similar to your Registered Retirement Savings Plan (RRSP), you’ll want to invest your contributions to ensure they grow. Once you decide to retire, you’ll have the choice of purchasing an annuity from insurance company, or transferring your account balance to a locked-in retirement income fund (LRIF).
|Defined Benefit (DB) Plan||Defined Contribution (DC) Plan|
|Philosophy||Rewarding long-service employees with a lifetime retirement income.||Assisting employees accumulate retirement savings during their career.|
|Investment Decision||Professional money managers look after investment decisions based on strict guidelines.||Employees decide how contributions are invested in a limited number of funds.|
|Investment Risk||Employer bears the investment risk.||Employee bears the investment risk.|
|Income at retirement||Based on a formula that includes your annual earnings and years of service.||Based on employer and employee contributions and investment performance.|
|Valuing Your Pension||Difficult, the commuted value is not readily available for most pension plans (except at termination).||Simple, as employees have their account balance readily available.|
|Options at Retirement||Start receiving your monthly pension, age 55 or older usually.||Buy an annuity or transfer your account balance to a LRIF; receiving income.|
What to Watch Out For
Not all DB and DC plans are created equal.
DB Pension Plans:
- CPP Offset: A lot of DB pension plans are integrated with Canada Pension Plan (CPP). That means you’ll receive a lower monthly pension from your employer to take into account the government benefits (CPP, Old Age Security (OAS), and maybe the Guaranteed Income Supplement (GIS)) you’ll receive.
- Indexing: Indexing is fairly common in the public sector and less common in the private sector. Indexing means your pension will increase annually to account for the rising cost of living. The amount your pension increases is usually based on the year-over-year change in the Consumer Price Index (CPI).
- Pension Insolvency: If your employer runs into financial trouble and isn’t able to meet existing pension obligations, it can affect the amount of pension you’ll receive. In Ontario, employees are protected by the Pension Benefits Guarantee Fund (PBGF). This fund covers the first $1,000 of your monthly pension. In all other provinces, employees will have to wait in line behind creditors for their pension entitlement. All this to say, you should monitor the funding of your company pension plan regularly.
DC Pension Plans:
- Past Performance: If your employer is responsible for investing your pension contributions, you’ll want to know about the past performance of your investment products.
- Investment Choice: As mentioned above, the employee bears the investment risk. Choosing your investment mix is very important to ensure you have enough income to retire. Similar to Group RRSPs, you should be able to choose from a variety of investments in your DC plan – just watch the fees.
- Pension Insolvency: If your employer runs into financial trouble, you’re better protected than DB pension plans since the funds are held in your own individual pension account.
How Many Canadians Have a Pension Plan at Work?
According to Statistics Canada, 38.4% of employees were covered by a registered pension plan (RPP) in 2012, down from 41.5% in 1997.
That means, in a snapshot, company pension plans have gone from commonplace to a workplace luxury. If you have a DB pension plan consider yourself lucky.
While DB pension plans remain (for now) in the public sector they’ve been disappearing from the private sector for years. With a lot of pension plans returning to fully funded status after the global financial crisis in 2008-2009, this has only encouraged employers to accelerate their de-risking plans.
What about the pension adjustment?
The pension adjustment (PA) was introduced in 1990 by the government to level the playing field for employees with company pension plans. The PA lowers the amount you’ll be able to contribute to your RRSP each year if you have a workplace pension plan.
Should You Even Contribute to Your RRSP When You Have a Company Pension Plan?
Whether you should contribute to your RRSP depends on how good your company pension plan is. If you’re a public sector employee with the “gold-plated” 2% of final average earnings as part of your DB plan, your pension will provide more than enough income in retirement if you have decades of employment under your belt. However, if you only have a 3% contribution as part of your DC plan, it probably won’t be enough in retirement – you’ll need to save more on your own.
Employees with a decent company pension plan should consider contributing to the Tax-Free Savings Account (TFSA) instead of the RRSP. That’s because when you withdraw money from your RRSP in retirement it’s counted as income on top of your pension income. This can cause a reduction in means-tested government benefits like Guarantee Income Supplement (GIS) and Old Age Security (OAS). Nothing is a guarantee in life, including company pension plans and any changes to them so you might consider contributing to your RRSP as a backup plan.
What type of pension plan do you have a work? Do you know how your pension plan works?
Sean Cooper is a financial journalist. He is a first-time homebuyer and landlord who aspires to be mortgage-free by age 31. He was inspired by Income Property’s Scott McGillivray to live in the basement and rent out the upstairs of his house. He is on Twitter @SeanCooperWrite and blogs on his personal website.