There are two common types of employer pensions in Canada: defined benefit and defined contribution plans.
- Defined Benefit Pension Plans (DB plans): Employees receive a guaranteed pension in retirement, based primarily on income earned and years worked. They are most common in government and public sector workplaces and to a lesser extent in unionized private sector companies.
- Defined Contribution Pension Plans (DC plans): Employers contribute a percentage of each employee’s earnings into an account, and the employee decides how the money is invested. They may also contribute their own money to the plan. The amount of income received in retirement is not guaranteed, and depends on the performance of investments. This arrangement is much more common with private sector employers.
“Defined benefit pensions used to be much more common, but in the private sector there are very few left,” says Senior Wealth Advisor Dave Lee from Scotia Wealth Management in White Rock.
Why defined benefit pensions have become increasingly rare
- They’re expensive: In a DC plan, the employers have no financial responsibility beyond the annual contribution they make for each employee. In a DB plan, however, the employee’s benefit lasts for their lifetime, is often based on their best five years of income, and increases with inflation. Some retirees will have more years in retirement than in the workforce, and their employer must set aside enough money to guarantee these pension payments.
- Employees don’t appreciate their value: With DC plans the full amount of this contribution is visible to the employee. In a DB plan, the employer’s cost can be as much as five times higher, but employees don’t see these contributions directly. Defined benefit pensions are extremely beneficial to employees, but many don’t recognize it. “Employers have realized that many employees will be just as happy to see contributions going into a DC plan, even if they’re getting much less money from their employer overall,” Dave says.
Many private sector companies have gone bankrupt because of the cost of funding their DB plans have become too high.
Who bears the risk?
- Defined contribution: Risk lies with the employee. The employer contributes a consistent amount, and it’s up to the employee to manage their investment. If the investments perform poorly, the employee’s retirement income will shrink.
- Defined benefit: Risk lies with the employer. The employer must contribute enough to the pension fund to pay lifetime income to employees. If investments perform poorly, inflation rises or retirees live longer, the employer must contribute more money to the pension plan to maintain the lifetime benefits.
DB plans are generally better for employees, but DC plans do have one advantage: flexibility.
“Far fewer individuals are working 40 years for the same company, and a portable pension can be useful when coordinating your retirement plan from job to job,” Dave says.
Take an active role in your retirement plan
With careful planning and sound advice from financial professionals, people with defined contribution pensions have the opportunity to create a comfortable retirement. But it’s important to take an active role: seek professional advice, learn about investing and optimize your savings.
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Dave Lee CIM, CFP, FCSI is a Senior Wealth Advisor with Scotia Wealth Management in White Rock. He can be reached at dave.lee@scotiawealth.com or 604.535.4743.
ScotiaMcLeod, a division of Scotia Capital Inc.