DC pension plans vs DB pension plans

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.

DC pension plan

The DC pension is more like a registered retirement savings plan (RRSP) in the way it works than what most people would traditionally think of as a pension. In this pension plan both employee and employer contribute to the plan. The amount invested is usually based on a percentage of income, up to a contribution limit. These contributions are then invested. The employee usually decides and directs what the pension plan

investments in, however, the employer also has a say.

Our government has a limit on how much each person can invest in a pension plan each year. This amount is called the pension adjustment. So, for every dollar contributed to the DC plan, the employee accumulates a dollar of pension adjustment. This means that the amount they can invest in their RRSP is reduced by a dollar. This is regardless of who makes the contribution. If the employee makes the contributions the contributions are eligible for a tax deduction. If the employer makes the contributions, they are not eligible for a tax deduction.

The government wants everyone to have a level playing field so the purpose of the pension adjustment is to equalize the retirement savings an employee with a pension can make versus someone who does not have a pension.

When a person retires and they have a DC plan, they have some options. The first is to transfer the value of the plan to a locked-in retirement account (LIRA). The second option is to use the money accumulated in the plan to purchase an annuity. The third option is to do a combination of the first two options.

To make it even more confusing changes in a recent federal budget, when a person retires with a DC plan, they can now choose aa variable payment life annuity (VPLA) or an advanced life deferred annuity (ALDA).

It is important when you are thinking about retirement and you have a DC plan that you talk to an advisor who can make sense of what you have and what you can do that is best for you. One of the first things you may want to look at is the current value of your pension. This is not complicated as all your advisor needs to do is to look at the value of the underlying investments in your plan.

What you don’t know (and this is why it is important to get impartial advice), is what future income this pension will produce. You have a defined contribution pension, which means the contributions to the plan are known, but your retirement income is dependent on the rate of return your investment earned and how much you have contributed over the years.

Employers like the DC pension plan, because it forces the employee to make retirement savings. By having it as part of the employment culture, with the savings coming right off of one’s pay, this type of plan encourages employees to save for their future.

Employees like this type of plan because the employer contributes to the plan. Each plan is different. Some employers may choose to match employee contributions, some may choose to make contributions regardless and some may combine the two in some fashion. No matter how they do it, the benefit is clear to the employee, it is free money toward their retirement savings.