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.
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.