There are two main types of registered pension plans in Canada – the Defined Benefit Pension Plan (DBPP) and Defined Contribution Pension Plan (DCPP).
A brief definition of both plans is as follows:
Defined Benefit Pension Plan
In this pension plan, the employer promises to pay you a predetermined monthly income for life after retirement.
The amount is calculated using different methods, but the formula is usually based on your average highest earnings and the number of years of service.
For example, a popular formula used for defined benefit pension plans is:
Annual Pension = 2% X average yearly pensionable earnings during the highest five earning years X years of pensionable service.
This formula may vary from employer to employer, but the idea is the same.
Both the employer and employee usually contribute to the plan and contributions are invested in a pension fund.
The employer manages the investment and the onus is on them to make sure that payments are made regardless of the investment performance. Essentially, the employer bears all the investment risk.
Defined Contribution Pension Plan
In this pension plan, both the employer and the employee contribute to the plan. The employee contributes a certain percentage of their annual income and this is often matched by the employer.
This is very similar to what happens in Group RRSPs, except that defined contribution is subject to pension legislation and lock-in restrictions which prevent withdrawals prior to retirement.
Unlike in a defined benefit pension plan, contributions to a defined contribution pension plan are invested for the individual in their personal pension account where the investments can be tailored by the employee to fit their own investment goals and risk profile.
At retirement, the amount received by an employee is dependent on the returns earned on the gross contributions. There are no guarantees.
Comparing both the DBPP and DCPP, it is easy to see that defined benefit pension takes the crown among pension plans.
Benefits of the Defined Benefit Pension Plan (It’s the Best Deal)
Compared to the defined contribution pension plan, a defined benefit plan offers more advantages:
1. Planning for retirement made easier: If you work for the same employer throughout your working years, you can reliably estimate your retirement income well before retirement.
If you change employers, you have the option to leave the pension in the current plan, transfer it to another pension plan or transfer it to a locked-in retirement savings account (LIRA).
2. Flexible dates for retirement: Depending on the plan, you may qualify to start receiving a full or reduced pension before you attain the age of 65. For my previous employer, the following options are available to plan members:
- Earliest eligible date: member eligible on 55th birthday
- Earliest unreduced date: the date a member reaches age 55 if age plus qualifying service totals 80 or more (Rule of 80), or reaches age 60 with 10 or more years of qualifying service or reaches age 65 regardless of service.
3. Flexible pay-outs: You can integrate your pension with the Canada Pension Plan (CPP) or Old Age Pension (OAS) in such a way that maximizes your income throughout retirement.
4. Survivor Pension: Pension plans have the survivor option where the surviving spouse continues to receive a certain percentage of the pension depending on the option chosen.
5. Indexing: The pension amount you receive is typically indexed for inflation using the Consumer Price Index (CPI). This ensures that your pension amount factors in the rising cost of living on an annual basis.
The State of Defined Benefit Pension Plans in Canada
The number of employees covered by defined benefit pension plans has declined steadily over the years.
In general, defined benefit plans are more commonly available to public sector workers and that is why the plan is sometimes referred to as a ‘gold-plated public sector pension’.
The decrease in the availability of defined benefit plans in the private sector is due to several factors including the liability and risk that companies bear if they have to make substantial contributions to make up for shortfalls caused by investment underperformance.
This was particularly obvious during the low-interest and low-return climate that unfolded after the 2008 financial crisis.
Governments are not left out of the debate on whether to ditch defined benefits and transition to defined contributions.
If you remember the Canada Post worker’s kerfuffle that occurred a few years ago, at the core of the dispute was the future of the company’s pension plan. Canada Post was considering switching the company’s pension plan from a DBPP to a DCPP.
In conclusion, the defined benefit pension plan is a really sweet deal! If your employer offers you a defined contribution plan instead, consider yourself fortunate.
As of 2013, almost 2 out of every 3 Canadian workers were not covered by any registered pension plan.