Defined benefit vs. defined contribution pension plans: which is better and how much will I receive?
Do you dream of one day being able to put your feet up and still collect a paycheque? If you work with a company that offers an employer-sponsored pension plan, you don’t have to dream. A pension is like getting a reward from an employer after years of service, providing a steady income when you’re ready to step away from work.
While a pension can provide a great foundation to help you retire on your own terms, they’re not all created equal. Not only do pensions vary between employers, but different types of pensions can affect how you prepare for retirement or even determine how long it takes you to get there.
Almost 40% of all paid workers in Canada still have a workplace pension1, although the types of pension employers offer have been shifting. Defined benefit (DB) pensions – once considered the gold standard for pensions – still dominate, but they’re becoming less common. As of 2022, 67% of all pensions were of the DB variety, down from 83% just 20 years ago.
Defined benefit pension plan
A DB plan provides a guaranteed source of income to a retired employee for life. The size of the monthly payout is determined by a formula that considers a number of factors, including their age, how long they’ve been with the company and earnings over their entire time with that employer. You can’t usually take the plan to another employer, which could limit the plan’s benefit if you change jobs.
Although both employer and employee contribute to the pension, the employer typically contributes at least half of the money employees eventually receive in retirement. With a DB plan, the employer assumes almost all of the investment risk, which is one of the reasons why fewer companies offer a DB option anymore. If a company falls on hard times or underfunds its pension obligations, it could put its pensioners’ savings at risk.
There are three main ways the pension a former employee receives gets calculated: final average earnings, career average earnings and flat benefit.
Final average earnings – This formula uses the average salary an employee earns during their final five years with the company and multiplies it by the total number of years they worked there and by an agreed upon benefit percentage. For instance, say you had an average salary of $77,000 over the final five years of your career, which is in line with what Statistics Canada says most Canadians aged 55 to 64 earn annually.2 If you participated in the pension for 30 years that offered a benefit percentage of 2%, your annual pension would be $77,000 x 30 x 2% = $46,200 or $3,850 a month, before taxes.
Career earnings – DB plans using this formula consider the average salary over an employee’s entire time with the employer, not just the final five years. For most Canadians, the average salary from ages 25 to 64 is $62,833. If you were part of the pension plan for 30 years with a 2% benefit percentage, your annual pension would be: $62,833 x 30 x 2% = $37,700 or $3,141 a month, before taxes.
Flat benefit – In this case, the formula uses a fixed monthly rate that is multiplied by the number of years an employee has been enrolled in the plan. If the monthly rate is $100, this means an employee’s annual pension would be 100 x 12 (months in the year) x 30 (years in the plan) = $36,000 or $3,000 a month, before taxes.
Defined contribution pension plan
A DC plan puts more of the onus on employees by requiring them to make regular contributions (usually a small portion of each paycheque), which the employer may choose to match. The main difference comes down to how the pension is run. The company selects a pension provider to facilitate the process, while the employee decides how those funds are invested. The size of the payout is based on how these investments perform (and not on a pre-determined formula based on their earnings).
For example, if an employee earns $77,000 and contributes 5% per year towards a DC pension, which is matched by their employer, it would be equal to a combined $7,700 per year. If their investments yield an average of 5% over 20 years, the pension would grow to $262,832 over that time.3
What are the advantages and disadvantages of each plan?
Advantages of a defined benefit plan
It pays out at least as long as you are alive – When you are part of a defined benefit plan, you don’t have to worry about outliving your pension. Many defined benefit plans also include a survivor benefit, so your spouse or partner may still receive a portion of the pension if you predecease them.
You know how much you’re getting – It’s easier to plan your retirement if you know how much money you have to work with.
The investment risk falls to your employer – You don’t have to worry about managing these funds, making retirement planning a whole lot easier.
You may have the option to retire early – Keep in mind, this might lower your monthly pension payments.
Disadvantages of a defined benefit plan
You may have to put in more time – Realizing the full benefits of a defined benefit pension may require you to stay with one company longer than you otherwise might.
You still have to rely on your company – If the organization you worked for struggles financially, your pension could be affected.
You aren’t in control – Your employer decides how to invest your pension dollars and you usually can’t cash out your investments early.
Advantages of a defined contribution plan
You decide how to invest your money – An employer may provide access to a specific financial provider, but you get to decide how the money is invested based on your specific goals.
Your employer will usually match some of your contributions – Who doesn’t like free money?
You have more access to your retirement funds – In addition to being able to see how much you have accumulated for retirement, you can generally transfer these funds if you switch employers.
Disadvantages of a defined contribution plan
There are no guarantees – The money you receive in retirement isn’t pre-defined but can fluctuate depending on how your investments perform. This presents a risk that you may live longer than your pension.
You have to put in the work – You’re required to manage your investments and ensure you have enough money for retirement.
Takeaways
Although the pension landscape is shifting away from defined benefit plans to defined contribution plans, both are great tools to help you build your retirement savings. While DB plans offer more predicable payments, DC plans provide greater flexibility, especially if you change jobs.
