Defined benefit vs. defined contribution: What is the best pension?
Author: Maria Smith
A company pension plan can be a great perk of the job. But unfortunately, only 37% of employees in Canada have access to a company plan. In the past, these plans would have been the gold-plated defined benefit pensions. But the shift towards defined contribution pension plans now puts more of the retirement planning responsibility on the shoulders of the employees and not the employer.
Are you part of the lucky 37% of Canadian employees who have a pension plan but are not sure precisely what that means? Keep reading to learn the difference between defined benefit and defined contribution pension plans.
What is a defined benefit pension plan?
A defined benefit pension plan is a traditional pension. It is one that provides a specific and predictable benefit (or amount of income) at retirement. Essentially, a defined benefit plan offers guaranteed income for life. And because of this, DB pensions are often referred to as gold-plated or golden handcuffs.
Usually, the formula dictates your defined benefit pension plan and includes your salary, years of service, and potentially your age. The calculation your specific pension uses may differ slightly, but most look something like this:
2% x Average Yearly Pensionable Earnings During Highest 5 Years x Years Pensionable Service
For example: 2% x ($100,000) x 35 Years = $70,000
With a defined benefit retirement plan, the employer takes on the investment risk and responsibility for ensuring that there is enough money in the investments to fund the pension payouts. These types of plans often require complex actuarial projections and insurance for guarantees resulting in higher administrative costs.
While defined benefit pension plans were once fairly common nowadays, they are usually only found within the public sector. The risk of DB pension plans is too much for employers in the private sector, so they opt for other options.
Benefits of a defined benefit pension
Employees prefer defined benefit plans, and it's no wonder with the many advantages they provide with minimal risk to the worker.
- Easier to plan for retirement – defined benefit plans provide predictable income, making retirement planning much more straightforward. The predictability of these plans takes the guesswork out of how much income you will have at retirement.
- Flexible retirement dates – most defined benefit plans offer an option to take early retirement, usually after 55. The amount of your retirement benefit decreases accordingly, but you could get up to 10 years of your time back, which may prove to be more valuable than the lost pension income.
- Flexible payouts – often, you can integrate your defined benefit plan with CPP and OAS, enabling you to optimize your tax efficiency. So more money stays in your pocket.
- Survivor benefits – depending on your DB pension's specifics, it may include survivor benefits for your beneficiary. If your plan does include this and you die before your spouse, your spouse or common-law partner may be entitled to a portion of your defined benefit plan.
- Cost of living adjustments – an added benefit of some defined benefit plans is the cost of living adjustment (COLA). Inflation will impact the amount you receive in retirement. Accounting for inflation is important because $50,000 a year now is very different from $50,000 a year ten years from now.
- Income splitting – After the age of 55, you can split your pensionable income with your spouse or common-law partner. Income splitting can provide a considerable tax advantage depending on the tax situation of both partners.
- The employer bears the risk – with a defined benefit plan, the employer carries the risk that the return on investments will cover the cost of the pension amount owed to retirees.
Disadvantages of defined benefit pensions
Although defined benefit retirement plans are known as gold-plated and provide guaranteed income for life, they do come with some disadvantages for the employee.
- Working longer than you need to – often, employees with a defined benefit plan work longer than they may need to because they become fixated on earning their "full pension" amount.
- Company managed fund – although the company bears the risk of market volatility, there is still a risk to the employee. The employer needs to manage the fund appropriately, or there may not be money to pay out as pension payments. If the employer mismanages the fund or goes bankrupt, there is a chance the plan members' future pension income could be affected. Sears anyone?
- Not always indexed to inflation – not all defined benefit plans are indexed to inflation. Ones that aren't are worth less money every year that passes. If you have a DB pension not indexed to inflation, you will want a secondary retirement income.
- An employee has no individual pension account – DB pension contributions are pooled into one investment fund. Plan members can often get projections of their future pension and current commuted value. But employees are not entitled to any of that money until they leave the plan or retire.
What is a defined contribution pension plan?
A defined contribution pension plan is one in which the employer and employee make contributions. Those contributions are invested over time to provide a payout at retirement. The final benefit amount of the pension is unknown because it is based on contributions and growth. And the investment returns are unpredictable and subject to market volatility.
The administration costs are relatively low with a defined contribution plan because the employer has no obligation to the plan's account's performance. The employee makes contributions and chooses what to invest in from the investments offered within the retirement plan.
Most defined contribution plans offer some form of contribution match up to a certain amount. If an employee contributes 10% of their gross salary, the company may match 50% up to $10,000. Here's what that would look like for an employee with a $100,000 gross salary.
[($100,000) x (10%) = $10,000] + [($10,000) x (50% of 10%) = $5,000] = $15,000
Contributions within a DC pension grow tax-deferred, and there are limits set on annual contributions. These limits include both employee and employer contributions.
A defined contribution plan may be known as a group RRSP, but it is superior to an RRSP due to matching employee contributions. This contribution match is like receiving free money or an instant return on your investment.
You may think that you could invest your money outside of the plan and get a better return. But that return would have to be better than the return you are getting in the plan and the contribution match. And this is highly unlikely.
Benefits of a defined contribution pension
- Vested immediately – many DC pension plans vest immediately or within a short time. Once your contributions are vested, that money entirely belongs to you. So if you were to leave the program or change employers, you would have options on what to do with your plan's investments.
- Ability to withdraw or transfer funds – depending on the plan rules, you may be able to remove or transfer funds before full retirement age. This is a valuable benefit if you change employers throughout your career.
- Choice of investment options – with a defined contribution plan, you, the employee, have investment decisions to make. This freedom of choice is not available with defined benefit plans.
- Individual pension account – because you have control over your investments, you have a separate pension account with a DC Plan. There is no pooling of funds between employees.
- Employer match – although the retirement benefit for a defined contribution plan is unknown, the employer match is much more predictable. It relates to the amount you contribute and may or may not max out at a specific dollar figure. The employer match is an instant return on your investment contributions.
Disadvantages of defined contribution pensions
- Limited funds to choose from – a benefit of a defined contribution pension is that you, the employee, get to pick in what to invest your funds. Unfortunately, those choices are limited to what the plan offers. The offered investments are usually mutual funds that come with slightly higher management fees.
- Unpredictable retirement income – with a DC pension, the end retirement benefit is unknown. The onus on you, the employee, to make sure that you are planning for retirement. Due to the unpredictability, this planning comes with a bit of uncertainty.
- The employee bears risk – the employee and employer contributions for a DC pension are subject to market volatility. The employee assumes the risk of this market volatility, with their final pension amount being something that is not guaranteed.
- The self-discipline required – employee self-discipline and savings habits are necessary to ensure that financial preparedness for retirement.
So, what is the best pension?
Whether it's a DB plan or a DC plan, you are winning if you have access to a company pension. While not all programs have mandatory or automatic enrollment, you will want to make sure you enroll as soon as possible. By doing so, you are opting in for free money.
It is also important to note that having a company pension plan does not let you double dip with your RRSP contributions. Your RRSP contributions will decrease in relation to your pension amount. This is so that there is not an unfair advantage created for someone with a company plan.
I would argue that if you have any form of company pension, you already have an advantage in your retirement plans compared to someone who doesn't. Regardless of the impact it has on your RRSP contribution room.
In the end, the defined benefit vs. defined contribution debate really doesn't matter. The fact that you have a pension makes all the difference, not which type it is.