Friday, May 8, 2009

Pension Plans - What Are The Differences?

With retirement being a hot topic in personal finance, one common question I get on pensions is what are the differences between a defined benefit pension plan and a defined contribution pension plan. Even though they have similar names, they have vast differences as to what it means for the retiree. They work differently and the resulting differences can be enormous.

Defined Benefit Pension (DBP)
A defined benefit pension (gold-plated) is just as it sounds. The payout, when it comes time to collect, is fixed to a certain formula. The formula is typically a combination of years of service multiplied by a percentage of your average salary over the last several years of service.
A typical government defined benefit plan will offer 60%-70% of the employees average salary over the last several years of service once they reach the 30 to 35 years of service mark. So for example, my wife is on a defined benefit plan with the government. When she is in her early-mid 50’s, she will have accumulated over 30 years of service at which point she’ll be entitled to around a pension of around 66% of her working pay. If she reaches the 35 years of service milestone, she will receive around 70% of her working pay during retirement.

Defined Benefit Plan Advantages

Retirement income is independent of market performance and usually adjusted for inflation. In addition, retirement income is relatively high (up to 70%) for the amount of contribution the employee makes. The higher income years prior to retirement really works to the employees advantage.

Downside of Defined Benefit Plans

Defined benefit pensions are extremely expensive on the employer which is why most companies are, or have switched, to a defined contribution plan instead. The biggest risk with having a non-government defined benefit plan is that there’s the possibility of the pension not being funded properly. Another disadvantage is that some DBP’s only allow a portion of the pension to be transferred to a spouse if the beneficiary passes away. Whereas an RRSP is more flexible where all assets can be transferred. They also limit contribution room for RRSP's.

Defined Contribution Pension (DCP)

Instead of the benefit being fixed, a defined contribution pension plan has a fixed contribution usually based as a percentage of the employees salary (usually employer matched). The benefit is dependent on how the portfolio performs with no guarantees as to how much income you’ll receive during retirement. For the astute investor, a defined contribution plan has the benefit of total control over the money/portfolio. The investor can choose various funds and asset allocation within the plan.

Defined Contribution Plan Advantages

You get to watch your money/portfolio grow; what you see is what you get. In addition, you maintain control over your money and investments within the plan.

Downside of Defined Contribution Plans

Within a DC plan, your retirement income is entirely dependent on how the portfolio/market performs over the vested period. Even an employee who has no interest in finances needs to be involved with the portfolio. As well, employees need to take advantage of the plan by maximizing contributions.

Final Thoughts

Typically speaking, an employee does not have a choice as to whether to to enroll in a defined benefit plan or a defined contribution plan. It’s usually one or the other depending on the company. Defined contribution plans are becoming more popular as they are much less risk to the company and arguably the employee as well.

Stay Well and Pay It Forward.

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