DB vs DC pension plans 2

2020 is the year many of us will retire or move away from the workforce. So, it is important that we understand the two main types of employee pensions in Canada, defined contribution (DC) and defined benefit (DB). Both are important and help you when you retire, though they both work in different ways.

The DB pension plan

The DB pension is what most people in Canada think of when they think of a pension. This type of pension provides a known future income stream to the employee – in other words, a defined benefit to the employee. For this pension plan, the employer and the employee make contributions to the plan that are invested to provide the future income stream. Depending on the investment performance, this may require more or fewer contributions from the employer.

The end result – a guaranteed income stream – is easy to understand.  To make the plan fair, the government uses a number of different formulas that determine your future benefit. The formulas involve looking at a person yearly maximum pensionable earnings (YMPE), their final average earnings (FAE) and years of service.

Some but not all DB pension have Canada Pension Plan/Old Age Security integration. This is where a bridge payment is made between when the pension commences and age 65. This means that if you decide to collect your pension at say age 60, the plan would pay you an amount (the bridge) until age 65. The bridge is meant to be equal to the amount of Canada Pension and Old Age Security that you are not collecting until you turn 65, Please note, this integration is not perfect as the bridge is often being different than the actual CPP and OAS received.

If the pensioner is married/common-law, then the DB pension will pay out a survivor benefit to the spouse upon the death of the pensioner if the pensioner is collecting from the plan. The default selection is typically 60 percent of the full pension amount, but a higher or lower percentage can be selected by the pensioner. A higher or lower percentage will raise or lower the actual pension payment because the payout is based on mortality rates.

Many Boomers end up getting a divorce around retirement age, so, there is a need to know what the pension worth today?  So, how much money is needed today to pay the employee a pension for the remainder of their life? The main factors that can influence this calculation include:

·       Age at retirement

·       Penalties for early retirement

·       Mortality of the pensioner and, if applicable, the spouse

·       Current age

·       Expected rate of return on the investments (often called the discount rate)

·       Pension indexed or not

·       Rate of inflation

The ability to calculate the value is important because if the employee dies before starting the pension, the surviving spouse does not receive a survivor pension. Instead, they may receive the commuted value of the pension eligible to transfer into their RRSP. This happens without tax implications, much like an RRSP rollover on death.

If you quit or are fired before you retire or die, then one option is to take the commuted value and transfer it into a LIRA in their name. Depending on the length of service, this is a common outcome.

Finally, at retirement, you can choose to take the commuted value instead of taking the pension if your plan allows for this to happen. Some of us want an increased choice about how to deal with this asset. Some of us believe that the commuted value can provide a larger death benefit for the surviving spouse. The full commuted value can provide more value. One only has to look at the collapse of Nortel or, more recently, Sears Canada to see examples of where a DB is not fully secure.

Each pension is different. It is prudent to take a look at what the breakeven rate of return is. In other words, what would the portfolio created from the commuted value have to earn to match the pension payments? If the comparable rate of return is reasonable, the pensioner may consider in their best financial interests to take the lump-sum.

One of the benefits of the DB, pension portfolio is the responsibility of the employer for the savings required and all of the investment risk in building retirement. This takes the decision to save for retirement out of the hands of the employee.

The value of the DB pension, especially if indexed to inflation, of a long-standing the employee will provide a solid base on which to retire. If someone worked 35 years at an employer with a DB plan, they could conceivably replace 70 percent of their pre-retirement salary if they had a pure 2 percent pension formula. Whether it is the more straightforward DC pension or the more complex DB pension, understanding how to maximize the benefits and choose the best options available are important steps on your road to financial independence.