Defined Benefit Plan
The defined benefit plan (commonly referred to as a “gold-plated pension”) has been on the decline over the last two decades, but it still represents a fairly large sample of the Canadian work force.
While the media and financial blogosphere continue to debate whether the best savings vehicle for retirement is the TFSA or the RRSP, approximately 29% of Canadian workers still have the luxury of a defined benefit pension to fund their retirement.
What is a Defined Benefit Plan?
A defined benefit plan is a pension that is based on your highest average salary and the number of years of your pensionable service. This type of pension plan enables you to plan for your retirement because you can estimate your future pension income in relation to your salary.
The pension plan assures you a pre-defined lifetime income, regardless of capital market conditions and how long you live. The defined benefit plan is financed by employee and employer contributions, and by investment earnings.
The contributions to your defined benefit plan are tax deductible. Each year your pension contributions, and your Pension Adjustment (PA), are reported to Canada Revenue Agency on your T4 slip.
Your PA estimates the dollar value of the pension you earned in a particular year (based on a formula under the Income Tax Act) and determines the amount, if any, that you can contribute to an RRSP. Canada Revenue Agency will advise you of the maximum RRSP contribution you can make each year.
What’s so great about a Defined Benefit Plan?
According to a 2008 research study by CGA-Canada on the state of the Canadian pension system, private savings cannot outperform defined benefit pension plans. Here is a summary of their findings:
- Private savings done outside of retirement savings vehicles would hardly reach half of the benefits level offered by the defined benefit plan, particularly in the public sector. For this reason, declining defined benefit pension plan coverage is received as bad news to many.
- It is simply not possible under the current tax rules to generate or to mimic the benefits bestowed by public-sector defined benefit pension plans.
- Maximizing RRSP contributions does not lead to achieving a level of pension benefits similar to that of defined benefit pension plans.
- CGA-Canada contends that private savings would have to be undertaken outside of tax-preferred saving instruments to produce similar benefits.
What to expect in Retirement?
In a defined benefit plan, the employee will receive the specified monthly income for the rest of their life. Most plans allow for payments to continue to their spouse or common law partner and some may also allow for inflation adjustments.
For example:
Let’s take the case of an employee making $80,000 per year who joins a defined benefit plan at age 35 and retires at age 65. The terms of the plan are:
- the employee contributes 10% of annual salary
- at retirement he receives 2.0% x years of service x best-5-average salary
The contributions and benefits would be calculated as follows:
- $80,000 x 10% = $8,000 contributed per year
- 2.0% x 30 years of service x $80,000 (average salary) = $48,000 (in today’s dollars) per year throughout retirement
Assumption: $80,000 salary grows at rate of inflation but all values are stated in today’s dollars
Defined Benefit Pension: Not Guaranteed
A company may change the terms of a pension plan or type of plan offered. For example, in 2008 Sears Canada froze their existing defined benefit plan and introduced a new defined contribution plan.
For affected employees, any benefits accrued in the defined benefit plan when it was frozen remain in that plan until your retirement age. Any future contributions would be made to the defined contribution plan only.
A company’s bankruptcy may also affect pension recipients depending on the status of the plan at the time. If the plan is fully funded at the time, there should be enough money to continue paying pensioners and to pay out a lump sum payment to non-retired employees.
However, if the plan is underfunded, employees will receive less than the promised amount. In some jurisdictions, the government provides a guaranteed minimum income to retirees. For example, in Ontario, the Pension Benefits Guarantee Fund insures pensions up to $1000/month.
A Clear Winner in Retirement
Experts will continue the debate between the RRSP and TFSA as the best choice for retirement savings. And private sector employers will continue to shift towards the defined contribution plan in order to save money and pass along much of the risk and ownership of retirement savings to their employees.
A defined benefit plan is becoming increasingly rare to find, but for those 29% of Canadians who currently have the luxury of a gold-plated pension, there isn’t any doubt that retirement is looking pretty sweet.
I have a DBP and this week we hope to learn Mrs. SPF has one as well. We aren’t taking them for granted however. After seeing what has happened to other DBPs we are still executing or financial planning to ensure that even with an alteration to the Ontario government DBP we will land solidly on our feet. And if the DBP is intact in 25 years we’ll be doing quite well. As such, we are focusing on our TFSAs and paying down the mortgage more quickly to allow us to execute the SM when we feel comfortable to leverage part of the paid off mortgage (certainly not all of it) by investing in blue chip Canadian dividend stocks.
New job for the Mrs? That’s exciting…with two defined benefit plans you shouldn’t have anything to worry about in retirement.
@Sustainable PF – for sure, with 2 DBPs, you’re set 🙂
@Echo – good post. I have a DBP, wife has DCP. We’re about 10 years into each. After another 15 years, when the mortgage is paid off, the plan is for one of us to retire because we’ll have dividend income to replace a portion of our salaried income. RRSPs wealth would be gravy. Probably my wife will retire with the DCP 🙂
Sounds like a good plan Mark, how nice for you to let your wife retire first 🙂
I have a DBP but you have to be working for 30 years to maximize it. My colleague is having early retirement in the next few years when she turns 55. Having 80% of your salary during retirement would be SWEEET.
Here’s dreaming! 🙂
Hi Y&T, the defined benefit plan is certainly more advantageous to those who stick with the same employer for the long term. I think the magic number is 85 (age + years of service) in order to max out your payments.
I also have a DBP, but being in the military, mine is slightly different. We’re lucky that the government recognizes us for our service to Canada and our pension starts the minute we ‘retire’, dependent upon the fact that we have served the minimum amount of time. For me it is 20 years, for the newer recruits it’s 25.
I could have ‘retired’ last week with about 1/3 my pay but I’m not in the position to do that just yet. Instead I will continue to serve my country for another 5 years and walk away at age 45 with just under 50% of my salary 🙂
I fully intend to continue working though, just in a completely different career. It is extremely comforting to know that I will not be left high and dry once I’m ready for the change – there aren’t exactly many comparable jobs out in the civilian side of things lol
One thing to keep in mind for DBPs is that while they are wonderful once you’re reached that milestone, they are a huge weight that can hang over your head if you’re no longer enjoying your job, yet have several more years to go to qualify… I’m lucky I’m not in that position!
Hi Sophie, thanks for sharing your story. Do you have your next career in mind yet?
I agree, the DBP is great but at the same time so many folks in the public sector get stuck in a rut and are just miserable as they count down the days until retirement. I’m glad you are not one of them and are enjoying your service.
Hi Sophie – Excellent work on reaching what I use to call the “beening in the drivers seat” of your military career. I retired from the CF 6 years ago with 21 years service. I too thought that i would do 25, but the demands were getting too much and I would have had to take a posting by myself , as my wife had an excellent career and was unwilling to give it up at that point. I went to work immediately and received a slightly lower salary than what i had when i retired. I did that for one year and then was lucky enough to get a new job that had another DBP and now make more than what did when i retired. I have spent very little of my military pension – buying RRSP’s instead. I plan on working in my new job for a total of 14 years before retiring fully (I think…) at 55. I am hopeing that at this point to have approx 400K in RRSP’s and my two DBP plans should equal out to approx 70 % of my pre- retirement wage. My wife will not get any pension from her employer, so we look at the RRSP’s as her pension plan. I think we are on the right track and certainly look forward to freedom 55. From one CF vet to another – Good luck to you in your CF career and all the best in your new one.
I recwived a letter from Social Security Administration on information acquired from your records stating that I might be entitled to additoinal benefits under pension plan type (M). I would like some clarification to this letter.
My plan #is 36-1750680-002. Thank you in advance for your coorporation
Galvester washington
I am part of a DBP with a large corporation that will change for me to DCP April 2013 as well as our company match for Rrsp’s will be discontinued..I have maxed out my RRSP contribution for the last 10 years to get the benefit of “free money” with the match..have to decide what to do with it at that point..these RRSP’s are with Sunlife that has “limited” investment options..any suggestions?….been reading so much about splitting between 3-4 index funds encompassing bond, Canadian, US & international based on percentage breakdown equivalent to age..I’m 52 next week & have 10 years to go for full Un-reduced pension..can I move these RRSP’s..probably about $45,000 by April 2013 to other investment vehicles without penalty? also, my partner (will be spouse shortly) has DBP as a letter carrier with Canada Post..& can retire with full pension in approx. 3 years @ age 55..also there was a lump sum payment that many postal employees took back in 2003/4..he did not..left his in to take advantage of the value of an increased hourly wage at the time it will be taken out & also more years as the calculation for payout (should be somewhere around $30,000 & thinking of putting into index funds)..going to a pension information seminar May 5 regarding this pension…any suggestions as to investing this lump sum amount….need to find out if it can be taken in 3 years & invested as we choose (even though he may choose to continue to work for a few more years because of 9 weeks vacation, great hours, & good hourly wage….& suggestion as to whether we should be maxing out our RRSP or TFSA or try to do both..mortgage will be paid in 7 years max. sooner if we step up payments..mortgage rate is 2.3% so wonder if we’re better off to invest more rather than pay down mortgage quicker..I have no Un-used room in my RRSP for contributions but he has approx. $75,000 in Un-used room…my pension is based on part-time hours of 32 whereas his is based on full-time wages..thought of purchasing rrsp’s into a spousal planwith his Un-used RRSP room with the lump sum payout but TD E-Series index funds because my taxes will be lower when cashing them out..any thoughts or suggestions would be helpful! I also have to make decision as to how my DCP will be invested next year I suppose as well..
@Barbara Mackay: Please keep in mind that I am not a pension plan expert but I will try to give you some general comments.
1. Pension plans do give you limited options. Check to see if they have made any changes to their selections since you first participated. Unfortunately, you can’t move the funds unless you quit your job and transfer the pension to a Locked in account.
2.By all means go to the pension seminar. They will give you more detailed information than I could attempt here.
3.Enroll with www:servicecanada.gc.ca to see what your projected CPP benefits will be. Then calculate your pension amounts for various ages. Remember to include any RRSP withdrawals – a rule of thumb is 4% annually. You want to see what your monthly income will be.
4.RRSP vs TFSA. There’s no point in contributing to a RRSP now to get the tax deduction if you will have to pay more tax on it on withdrawal. That’s why you need to calculate your retirement income. Personally (and this is just me) I would first maximize the TFSA contributions as those withdrawals will be tax free.
5. Investments are a personal decision depending on whether you still have time to go for growth or if you will need some income (and tolerance for any risk). Index funds are a good low cost option. Remember if you buy growth funds in your RRSP you will have to eventually withdraw the funds. You don’t want to end up losing money if the market takes a downturn.
6. I would try to pay off the mortgage before your retire. Even with a low interest rate you are still making payments. Wouldn’t you rather have the $500-$1000/month for fun?
In this world of moving around, most DB people won’t be staying in one job for the 30 plus years to take full advantage of a DB plan. Also, most DB plans are integrated with CPP. This does not apply to DC plans. Can you explain how this works. Thanks