Some company pension plans are voluntary. Some are mandatory. Some have different levels of contributions or optional features. The starting point for assessing any pension plan is understanding the difference between a defined benefit (DB) and defined contribution (DC) pension plan.
Defined benefit pensions
A DB pension entitles a plan member to a future benefit that is based on a formula. It might be something like 2% times your years of service times your average salary in your final three years of work, as an example. So, 2% x 30 years of service x a $100,000 final average salary would result in an annual pension of $60,000.
A DB pension is predictable and is not directly subject to stock market volatility for a plan member. When the pension begins, it is a pre-determined monthly payment.
If you retire before a certain age, and you do not have enough years of service, your pension may be subject to an early retirement discount. That may apply, for example, if you retire before age 60 and have fewer than 25 years of service or some similar combination of factors. Every pension is different.
I find DB pension plan members often fixate on their unreduced pension date—the date when their pension is no longer subject to a discount and the regular pension plan formula applies. As a retirement planner, I find this fixation odd as it is kind of like saving in a Registered Retirement Savings Plan (RRSP*) and not retiring until the account is worth $1,000,000. If you only need $750,000 to retire, why keep working longer just to reach an arbitrary goal? Or if you had $1,000,000, you were only 50, and still wanted to keep working, why not work until you feel like retiring? My point is to try to plan retirement based on personal factors, not to fixate on a date on your pension plan statement.
Contributions you make to your DB pension plan re tax-deductible: They reduce your taxable income and generate tax savings. At the same time, pension contributions reduce Registered Retirement Savings Plan (RRSP) room so that pension plan members do not have an unfair advantage over non-pension plan members. The calculation of how much RRSP room you lose when you are in a DB pension plan is complicated, but basically it is a function of how much future pension you earned in the year and how much an RRSP contributor would have to contribute to their RRSP to receive the same future income.
If you leave a DB pension before you retire, or before a certain age, you may have an option to transfer the commuted value of your pension to a locked-in RRSP account. A commuted value is a calculation of what your future pension benefit may be worth as a lump-sum payout today. Payouts are higher when interest rates are lower, on the assumption that you will invest the payout at low-interest rates. Part of a commuted value payment may be taxable, and not all may be able to be sheltered by a locked-in RRSP.
Electing a commuted value payment from a DB pension can be complicated and may or may not be advisable. It means you are giving up your future monthly pension payments and taking on investment risk to manage the money yourself. On the other hand, there may also be an option to use a commuted value to purchase a copycat annuity—basically, buying a future monthly payment from an insurance company—that provides the same income plus a cash payment.
higher income than your company’s DB pension plan formula.
DB pension income after age 55 is eligible to split with your spouse or common-law partner on your tax returns. Pension income splitting can equalize unequal incomes in retirement and minimize a couple’s family (combined) income tax.
When you start your DB pension, you may have options about the survivor benefit payable to your spouse in the event you die, and they are still alive. Survivor benefits may be a percentage of the pension—ranging from 0% to 100%—or may guarantee a certain number of years of payments even if you die before your partner.
Defined contribution pensions
A DC pension has contributions that go into mutual funds. Those mutual funds are subject to stock and bond market fluctuations, as the investments will rise and fall. The pension’s future income will depend on how the investments perform.
Some companies have mandatory employee contributions, mandatory employer contributions and an optional component. The optional contributions may be a percentage of salary up to a stated maximum. Employee contributions often attract employer matching contributions as an additional incentive to save: You contribute and your employer will match a portion or all of your contributions—50%, 100%, etc. An employer match may be subject to an annual dollar maximum.
Because of the matching contributions, DC pensions are better than RRSPs. A DC pension contribution and an RRSP contribution will save you the same amount of tax, but the added benefit of the employer matching contribution makes a DC pension superior.
Employee DC pension contributions are tax-deductible and, like DB pension plan membership, a DC plan member will have their RRSP room reduced based on their and their employer’s contributions, so they do not have an unfair advantage over those without a pension plan.
DC pensions tend to have a shortlist of mutual fund options for plan members, and those funds generally have low fees. The fees can range, though, depending on how competitive a plan an employer has negotiated for their employees. (I have seen some terribly expensive plans in my professional experience.)
More often these days, the mutual fund options include target-date funds so plan members can pick a fund whose target date is close to their own retirement date. The further from retirement, the more stocks will be in the fund. Closer to retirement, a target date fund will be invested in fewer stocks and more bonds—and more conservatively.
Target date funds may be easier than a plan member trying to build their own diversified portfolio of Canadian, U.S., and international stocks and bonds with an appropriate asset allocation. But that is not to say the target date fund will be more “appropriate”—just simpler.
Is there ever a time when you might consider opting out of your employer’s DC plan—maybe you think you could do better investing the funds on your own? Even if the fees were high, or the investment options were bad, let’s say there is a 50% annual match on contributions. You would need to earn a 50% higher return somewhere else net of fees to forgo participation. So, I would almost never forgo a DC pension plan unless someone had a really horrible financial situation and high credit card debt and a low or possibly no employer matching on their DC pension plan contributions.
As far as opting out, every plan is different. Some plans have a mandatory contribution, even if it is just a mandatory employer contribution from the company whether the employee contributes or not. Others have a minimum employee contribution.
Usually if you opt out of a DC pension, the worst thing that happens is you forgo future matching contributions. Past contributions are generally “vested” (belong to you) immediately in a DC plan.
When you leave a DC pension plan to go to a new job or to retire, you generally have the option of leaving the money in the plan or transferring it to a locked-in RRSP*. The locked-in RRSP can be at the existing DC pension plan provider (often an insurance company) or an outside financial institution of your choice.
DC pensions and locked-in RRSPs are like regular RRSPs and have minimum withdrawals that must begin no later than age 72. Unlike regular RRSPs, there are specified maximum withdrawals from a locked-in RRSP to ensure you don’t take out too much, too soon, and so helping to preserve your pension throughout retirement.
Because DC pensions are more variable and retirement income depends on investment performance, they may be seen as less desirable than DB plans for plan members. However, employers prefer DC plans because their financial obligation is limited to whatever contributions they promise to make for employees, while companies with DB pension plans are on the hook for paying promised monthly pensions if the contributions are invested poorly and the pension fund has a shortfall. Increasingly, employers are moving from DB pensions to DC pensions for new employees, or sometimes moving their entire DB pension plan to a DC pension.
DC pensions are at a disadvantage to DB pensions because locked-in withdrawals are not eligible for pension income splitting until age 65. So, a pensioner with a DC pension will not be able to move eligible withdrawals to their spouse or common-law partner’s tax return to minimize their combined tax as a couple until they are 65.
Pension plans are employer-provided benefits and tools for employees to save for retirement. There can be company-specific nuances that go beyond the considerations discussed, but both employers and employees should do their best to maximize pension plan participation.
DB and DC pensions may differ, but both can be great tools to save for retirement. Plan members should do their best to understand their pension, how to maximize it, and how much income it will provide to them in the future, in retirement.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.
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