Types Of Pension Plans And Their Pros And Cons

There are three main pension arrangements in Canada and most people, if they have a pension plan, have one of these three main types. There are defined benefit pensions, defined contribution pensions, and group-RRSPs. Each of these have their pros and cons. (There are also some unique pension plans but these are typically intended for high income executives or business owners.)

Having an employer pension plan can be a huge benefit for retirement. An employer pension makes saving for retirement easier by taking deductions directly off your income, plus it also typically comes with employer matching. This employer matching can be worth anywhere from a few percent of your salary all the way up to 18% of your salary (depending on the plan and the retirement benefits provided).

The automatic nature of pension contributions make them a great way to save for retirement. This “forced savings” is a huge benefit in itself, regardless of the employer matching.

Depending on the type of pension you have, this money gets paid out in different ways at retirement. Some plans cannot start before a certain age while others can be accessed earlier. Depending on your retirement goals this flexibility (or lack of flexibility) is an important consideration in your financial plan.

Some pensions, specifically defined benefit pensions, may also come with health benefits, travel benefits, or life insurance benefits after retirement. This can be another important benefit of a defined benefit pension plan, one that shouldn’t be ignored (especially when deciding between a defined benefit pension and a commuted value option).

It pretty much always makes sense to participate in an employer pension plan, but the different plans do have their pros and cons. Let’s explore the three main types of plans in Canada and their pros and cons.

Defined Benefit Pension Plans

Defined benefit pensions are one of the most common types of pension plans in Canada but the number of defined benefit plans has been in decline over the last 10-20 years. They’re great for the employee but not great for the employer.

With a defined benefit pension plan (DBPP) you know how much pension you will receive at the start of retirement based on a formula. To calculate this amount, the formula is typically some combination of:

• Number of years working for the company (years of service)
• Your average salary (best 5, average lifetime etc)
• An agreed upon percentage multiplier (1.5%, 1.75%, 2.0% etc)

For example, someone who has 30 years of service, with a “best 5” of $60,000, and a pension that pays 2%/year of service might expect to receive $36,000 per year at retirement.

With this type of pension plan, you are not actively involved in day to day decisions and it is up to a team of portfolio managers to manage your funds. This can be a huge benefit to those people that do not wish to manage their own investments.

The average salary that is used to determine your retirement pension can be different things depending on your plan, it could be your best 5-years, average lifetime earnings, or something else entirely. In either case, your pension will typically be impacted by your earnings over the course of your working years.

Defined benefit pension plans typically have an “earliest retirement date” based on age and years of service. This might be reduced pension based on the number of years before your normal retirement date or an unreduced pension. The challenge with a defined benefit plan is that it’s hard to retire before your “date”, this makes early retirement more difficult.

Pros

• Guaranteed pension for your whole life (no longevity risk = big advantage)
• You have a good idea of what your pension will end up being at retirement based on your formula
• Your pension is sometimes protected against inflation
• Your spouse or dependants may be eligible to receive your pension in the event of your death (but typically with a large reduction)
• Don’t have to worry about investment risk
• Pension income splitting before age 65 (a huge tax benefit for couples!)
• Possibly other retirement benefits like health benefits, travel benefits or life insurance benefits

Cons

• Harder to leave employer (there are often complex decisions to make)
• Little control over investments
• Expensive to maintain (and lots of risk for the company, which is why companies are providing DB pensions less and less)
• Sometimes survivor benefits are limited to 50% or 60% unless you “buy” more in exchange for a reduced pension payout
• Sometimes there is no inflation protection
• Not very flexible, often it is very difficult to retire before your “date”
• Smaller pensions can be terrible for low-income retirees receiving GIS, there is not a lot of flexibility to manage income
• Counterparty risk if the pension is underfunded

Defined Contribution Pension Plans

A defined contribution pension plan (DCPP) works so that you know how much you are contributing to it, but not how much you will eventually receive. There will be an agreement between you and your employer deciding what percent of income will be placed in the pension plan monthly (or a fixed dollar amount per year). This amount might include a match from your employer.

How much you receive from a defined contribution pension will depend on how your investments perform. This will also depend on what investments you choose and the mix of those investments. With a defined contribution pension the company is transferring the investment risk to the individual employee.

Contributions are typically based on a percentage of income (typically salary/base income but could also include bonus income). An employer might match contributions at a certain rate… for example.

Examples of DCPP Matching:

• Employer contribution 100% match up to 3%, Employee contribution 0% to 3%
• Employer contribution 3% base plus 75% match up to 3%, Employee contribution 0% to 4%
• Employer contribution 4% base plus 50% match up to 4%, Employee contribution 0% to 8%

Contributions to a defined contribution pension plan are limited by the RRSP limit of 18% of employment income up to the max. Contributions decrease next year’s RRSP contribution room through something called a pension adjustment. During tax time you’ll receive a pension adjustment value on your T4. This will reduce the RRSP contribution room you have for next tax year.

Pros

• Full control over investments
• More flexibility with retirement withdrawals
• Easy to understand how much you have
• Easier to leave employer and move pension into a LIRA
• Easier to manage income when qualifying for GIS benefits

Cons

• Individuals bear 100% of the investment risk
• Need to make all the investment decisions yourself
• Not protected against inflation
• May outlive your pension (no longevity protection = big risk)
• More flexibility with retirement income however when a LIRA is converted to LIF there are maximum annual withdrawals in most provinces and they’re typically limited to age 55+

Group RRSPs

Group RRSPs are similar to defined contribution pension plans but there are some subtle differences. Similar to defined contribution pensions, the employer may offer matching of employees contributions at a certain rate with a group RRSP. But unlike a defined contribution pension plan there is more flexibility on both the size and timing of withdrawals.

With a group RRSP you can still have an individual RRSP, but make sure to not surpass the contribution limit of 18% income (max of $26,500 as of 2019). This limit is based on last years income and can be found on your Notice of Assessment. This limit acts as a total for all RRSPs put together, this includes your personal RRSPs and group RRSPs, so make sure to add everything up and don’t go over or expect some penalties!

Although your employer will provide you with investment options within the RRSP, like a defined contribution pension plan, it is up to you as to how you will invest your savings.

Pros

• Full control over investments
• Very flexible, many plans allow for withdrawals at any time or after a certain amount of time
• Easy to understand how much you have
• Easy to leave employer
• Easier to manage income when qualifying for GIS benefits

Cons

• Individuals bear 100% of the investment risk
• Need to make all the investment decisions yourself
• Not protected against inflation
• May outlive your pension (no longevity protection = big risk)

Financial Planning With A Pension

Financial planning with a pension will depend on what type of pension you have. They all work a little differently so it will depend on what type of pension you have and the specifics of your pension.

A simple thing like inflation protection on a defined benefit pension can make an enormous difference over time. Or investment fees in a defined contribution pension or group RRSP can also create a significant drag on retirement savings.

Each type of pension has its individual pros and cons. How your pension integrates into your financial plan will depend on your individual goals.