One of the best employer benefits available is a pension plan which comes in two forms: defined benefit pension plan and defined contribution pension plan. Think of it as free money since your employer is basically matching you, or giving you more, towards your retirement savings.
Despite the fact both pensions are essentially free money. Many people hesitate to join. Some just can’t afford to have a set amount taken off their paycheque every pay cycle while others don’t understand how pensions work and think they can do better on their own.
Let’s be clear, you’ll almost always come out ahead with a pension plan which is why you need to join yours as soon as you can. If you do have access to a pension, it’s important to understand what the differences are between defined benefit vs defined contribution pension
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 (usually around 2%). Since your salary changes over the course of your working years, the formula is typically based on your 5 highest earning years or the last 5 years of your employment.
For example, let’s say you have defined benefit pension plan where the formula used is the average income of your last 5 years. Let’s assume your average income for those years was $100,000 and you were in the pension for 35 years. Your formula would look something like this.
35 X $2,000 (2% of $100,000) =$70,000 per year when you retire
This is strictly a generalization since every defined benefit pension plan formula is different, but you can see how valuable a DB pension 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.
It’s also worth noting that not every defined benefit pension plan is indexed to inflation. $70,000 a year may sound great right now, but it may not be worth as much in 35 years.
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 and switching to defined contribution.
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.
To make things fair, the CRA implements a pension adjustment for people who have a DB pension. This adjustment reduces your RRSP room which some people find unfair, but they also have a guaranteed payout when they retire so they’re getting no love from me about this complaint.
Even if you don’t plan on staying at your company forever, it’s still worth signing up for your pension. You can transfer your pension when you leave so there’s no loss to you.
Defined contribution pension plan
- Employer contributes a set amount
- Employee bears the market risk
- 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 a defined benefit pension plan, but it’s still free money so try to max out your plan. In addition, it’s up to you as the employer to select what investments you want. You could do well, but if you’re not paying attention to your portfolio, you could be doing yourself harm.
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 or they’ll give you an 11% match if you contribute 10%.
Let’s say you make $100,000 a year and your employer has a defined contribution plan where you can contribute up to 10% of your income and they’ll match it by 50%. Your defined contribution pension plan formula would look something like this.
10% of 100,000 = $10,000. 50% match of 10,000= $5,000 per year
Although the above formula calculates the entire year, defined contribution pension plans are taken off every paycheque. Every plan is different, but generally speaking, the actual investment is made once a month.
Most employers will be working with one specific investment firm and you’ll need to choose from their funds. Quite often this means you have limited choices, but there’s usually still a few decent funds that will work for you. ETFs may have a lower management expense ratio compared to what your fund options are, but you’re getting free money from the employer so you come out ahead no matter what.
Using the above example, you’re guaranteed a 5% return and that’s assuming you do nothing with the funds you’re investing. One strategy that people use is to transfer their funds to their own RRSP whenever it’s allowed so they can invest in lower cost products.
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?