Last week I wrote about the defined benefit plan, and how almost a third of the Canadian workforce is still fortunate enough to receive this gold-plated pension plan to fund their retirement. But defined benefit pensions have been in decline over the past two decades in favour of the defined contribution plan, where plan membership has doubled over the same time period.
What is a Defined Contribution Plan?
In a defined contribution plan, the employer specifies how much will be contributed to the plan on a regular basis. Investment of the funds is generally directed by the employees from a selection of investment options available within the plan.
This is similar to managing a personal RRSP. The amount a retiree will receive will vary based on the amount contributed and the performance of the invested funds over time. The defined contribution plan offers more flexibility for an employee than a defined benefit plan but puts all the investment risk on the employee.
The contributions made to your pension plan are tax deductible and accumulate on a tax-deferred basis. 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.
Why do Employers Favour a Defined Contribution Plan?
According to a 2008 research study by CGA-Canada on the state of the Canadian pension system, the recent financial crisis along with a string of high-profile bankruptcies highlighted the need for broader, more far-reaching reforms to pension legislation and the other side of defined benefit pension plans – the risk that an employer fails to fulfill its pension obligations i.e. Nortel. The shift to defined contribution plans were due in part to the following reasons:
- Unlike a defined benefit plan, a defined contribution plan affords certainty of expense and cash flow for the employer and hence assists in planning controlling and monitoring risk.
- A Defined contribution plan allow the employee to exercise greater control over retirement planning and increased adaptation to their own individual circumstances and lifestyle.
- A Defined contribution plan impose ownership responsibilities on the participants for shaping their working lives and retirement expectations.
What to Expect in Retirement?
In a defined contribution plan, at retirement age they will receive all of the funds which they have contributed, those which their employer has contributed, as well as all accumulated investment income. At retirement, they have the choice of transferring the defined contribution plan funds to a locked-in RRSP, a Life Income Fund (LIF) or an annuity. Retirement income will depend on the option(s) chosen.
Let’s take the case of an employee making $80,000 per year who joins a defined contribution plan at age 35 and retires at age 65. The terms of the plan are:
- the employee contributes 4% of salary matched by the company also contributing 4%
- employee contributes an additional 3% of salary matched by the company contributing an additional 1.5%
The contributions and benefits would be calculated as follows:
- total combined contribution is 12.5% of the employee’s annual salary per year
- $80,000 x 12.5% = $10,000 contributed per year ($5,600 employee, $4,400 employer)
- The retirement income will depend on the actual rate of return achieved on the investment over the 30 years in the plan and the life expectancy of the retiree.
Possible results (stated in today’s dollars) are:
- $35,000/year to age 83, assuming an investment rate of return of 6%
- $27,000/year to age 83, assuming an investment rate of return of 5%
Assumption: $80,000 salary grows at rate of inflation but all values are stated in today’s dollars
Defined Contribution Plan: Manage Your Own Risk
A defined contribution plan offers an employee more choice and flexibility in their investment than a defined benefit plan. This allows a knowledgeable investor to tailor the plan to suit their own investment goals and tolerance for risk.
Someone who is less comfortable with investment decisions must still be careful to put the same effort into pension plan investments as any other registered or non-registered investments they may have. This includes understanding their asset allocation mix and risk tolerance.
A defined benefit plan fits the traditional view of company-provided, guaranteed retirement income and there are still many of these plans available in Canada. But as defined contribution plans become more common in the private sector, it is important to understand what type of plan you have and how to incorporate it into your overall retirement strategy.