When I pick topics to write about I try to select general topics so it applies to everyone. I want all my readers to be able to get something out of my writings, by sometimes topics need to be specific for one reason or another.
Today I want to talk about pension plans. Even if you don’t have access to a pension, it’s important to know how they work just in case you get access to one in the future. Your employer might already offer a pension and you may not even know it – after all, they rarely advertise this amazing benefit.
Pensions really come down to 2 categories: defined benefit vs defined contribution. To simply put it one is better than the other, and depending on which pension you have, either you or your employer will bare more risk. It’s a little more complicated than that so below you’ll find a breakdown of defined benefit vs defined contribution
Defined Benefit Pension Plan
- Set income when you retire
- Employer bears the market risk
- Good income compared to what you put in
As the name implies a defined benefit pension plan gives you a fixed income when you retire. The formula used to determine your yearly payout is usually years of service multiplied by a percentage of your yearly salary. Our salary changes over the course of our working years so most of the time the formula is based on our 5 highest earning years or the last 5 years of our employment.
An employee with a defined benefit pension plan, who served 35 years with the company, and made an average of $70,000 in their final 5 years would see the following payout.
35 X $1,400 (2% of $70,000) =$49,000 per year when retired
This is strictly a generalization since every pension formula is different, but you can see how valuable a defined benefit pension plan can be. It’s often referred to as gold platted since it is fully guaranteed – you know exactly how much your payout is. Not all defined benefit pension plans are mandatory, so make sure to sign up as soon as you can since the earlier you join, the more money you’ll get paid out.
The cost to you as an employee varies depending on the payouts offered by the plan. Generally speaking the more valuable the plan, the more you pay in, so that could be anywhere from 4 – 15% of your gross income. It may sound like a lot but the payouts are so valuable that it’s totally worth it.
There are some risks when it comes to this type of pension. Since the employer is responsible for the payouts, they need to make sure that the plan is well funded and that the assets held are enough to make yearly payouts for everyone collecting. This type of pension is very expensive to maintain and is the major reason why most companies are getting rid of their defined benefit pension plans. Survivor benefits of pensions can sometimes be limited. It obviously depends on each individual plan, but it’s possible that survivor benefits last only 10 years. This might be fine for some people, but if the pension is your only source of income when you retire, it may be a problem.
Defined Contribution Pension Plan
- Employer contributes a set amount
- Full control over your investments
Instead of having a fixed retirement payout, a defined contribution pension plan offers a matching contribution up to a certain amount. This is nowhere near as valuable as defined benefit pension, but it’s still free money so try to max out your plan.
With a defined contribution pension plan, your employer will usually match you a certain amount when you make a contribution to a group RRSP plan. The contribution might be something along the lines of a 50% match up to a maximum of 10% of your gross income, so if you made $70,000, what you would get from your employer is as follows.
50% of $7,000 (10% of $70,000) = $3,500 total payment per year
This lump sum is paid immediately (vesting may apply) and is no longer the employers responsibility once it’s paid out. It’s up to the employer to invest the money on their own. These matches will require you to pick a fund to invest in so some basic research is required.
When looking at defined benefit vs defined contribution pension plans, clearly the DB plan comes out on top, but it’s free money no matter how you look at it. There’s no reason to not join your pension plan pension plan, it doesn’t matter if you’re already saving with your RRSP or if you have other savings in place, why would you not want free money?[/fusion_builder_column][/fusion_builder_row][/fusion_builder_container]