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Defined Benefit Pension vs Defined Contribution Pension





With retirement being a hot topic in personal finance, I get a lot of questions regarding the differences between a defined benefit pension plan and a defined contribution pension plan.  Even though both have similar names, they have vast differences as to what it means for the retiree.

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.

The Advantages

  • Retirement income is independent of market performance and usually adjusted for inflation.
  • 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.

The Downside

  • 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.

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.

Advantages:

  • Watch your money/portfolio grow, what you see is what you get.
  • Control over your money and investments within the plan.

The Downside:

  • Retirement income is entirely dependent on how the portfolio/market performs over the vested period.
  • Even an employee who has no interested in finances needs to be involved with the portfolio.

Final Thoughts

Typically speaking, an employee doesn’t 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.





35 Comments, Comment or Ping

  1. 1. Brandon

    Something to point out about the DCP is that most (all?) of them cannot be used with the HBP.

  2. 2. Traciatim

    What is the benefit of a pension plan over a employer matched RRSP or RRSP/DPSP combo?

  3. 3. Scott

    DISCLAIMER: more rant than helpful comment.

    My two cents on why (yet again) the government is a bloated, uncoordinated lame duck:

    I work for a provincial government. When I got the job, my pension was stated as being “Defined Benefit” — that is, “retirement income is INDEPENDENT OF MARKET PERFORMANCE and usually adjusted for inflation.” A couple months later I received a letter saying employee contribution levels were being raised because the pension plan was failing to meet projected returns. Independence, my a$$.

    I guess in times like this I should be grateful I do have a (secure?) pension, but on the other hand, should I be grateful that my government can’t get it together? Hire a couple actuaries and a statistician for god’s sake!

    I’ve even tried to have RRSP contributions taken off my pay, but I’ve been told “we aren’t set up to do that”. Huh? It’s not hard, you ARE the government after all!

    Sigh.

    Absolutely no disrespect to your wife, FT, but I can’t imagine doing a 30-35 year stretch in a gov’t job just for the pension (ie. selling my soul for mere money).

  4. 4. cannon_fodder

    FT,

    Is my understanding correct that if while you are part of a DBP your RRSP contribution limits are affected, i.e. they are reduced based on a formula that uses the amount that your employer puts into the plan?

  5. Traciatim, are you asking the comparison between a rrsp vs DCP or RRSP vs DBP? Employer matched RRSP is pretty much the same thing as DCP. DBP is vastly different as payouts are fixed to income and independent of the market. To get a 70% retirement income based on a regular DCP or RRSP would require a much larger contribution than what’s required of employees with a DBP.

    Scott, LOL, you sound upset? :) To each their own, but some people really enjoy their jobs and are not working simply for the pension. I personally can’t imagine working at something that I disliked for 30 years simply for a secure retirement.

    Cannon, yes RRSP contributions are severely limited when an employee is on a DBP. With the high income in retirement though with a DBP, it would probably be best to contribute to the TFSA instead. That would keep taxes lower during retirement and reduce the chance of testing the OAS income limits.

  6. 6. Millionaireby45

    FT,

    There has been a lot of talk lately about DBP’s due to the possibility of GM going bankrupt. I have heard on the news that the Ontario government may be liable for these pensions. Do you have any info on this? Is each province liable (or is Ontario different), and how much are they liable for?

  7. c_f – my understanding is that any contributions to your pension plan by you or the employer count directly against your rrsp room which would often limit the rrsp room quite a bit.

    As FT points out – if you have a good pension plan then the benefits of an RRSP are diminished anyways so TFSA is like a better option.

  8. 8. The Reverend

    A couple comments:

    – regarding “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.” I think this is false. At retirement you are usually provided with an benefit option form which provides an array of options: payments for life, payments for life with a 5 or 10 year guarantee, payments for life with a % continuing to a surviving spouse. For each of these options, the benefit payment is reduced/increased accordingly so that they are actuarially equivalent (eg $1 per month for life might be equivalent to $0.90 cents for life with 50% continuing to spouse upon death).

    - regarding “Employer matched RRSP is pretty much the same thing as DCP” – be careful about this. There are a few key differences one should know. RRSP contributions are limited based on last year’s income. DC plan contributions reduce next year’s contribution room. Can make a difference if income is volatile. Also, and more importantly, RRSP contributions can be withdrawn whenever you want (pre-retirement, post retirement, lump sums) where as pension plan contributions are locked-in. You can’t withdraw them pre-retirement, and even in retirement you can only withdraw within specific upper and lower limits (i don’t know them off hand).

    - also, there’s a pension benefits guarantee fund, which plan pay premiums into in the case of a pension insolvency. this reduces the risk of your plan defaulting if you’re a corporate db plan. i don’t agree with the point that DB plans are “arguably” riskier than DC for the employee. if the DB plan were to default and you only get 50 cents on the dollar, chances are a DC plan wouldnt’ have faired all that well either.

  9. 9. The Reverend

    - re: “Even an employee who has no interested in finances needs to be involved with the portfolio.”

    I think things have improved on this front with “target date” funds being offered pretty broadly. it used to be that if you didn’t go in and choose your specific fund line-up, the employer wasn’t allowed to default you into anything but a money market fund (they can’t choose your risk profile for you). now a lot of plans will default people into a target date fund based on when they would turn 65.

    - another advantage of DC plans is the lower MERs offered. depending on how large your employer is, you can get some relatively low rates compared with the average mutual fund out there (though not much better than TD e-series).

  10. 10. AndrewP

    I am extremely happy with my DCP at work since the employer matches 100% of contributions. No matter what fund I choose to pool that money towards, I’ve automatically doubled my money!

    If the fund decreases in value by 4% over a year, my portfolio is still worth about 92% more than what I put in (compounding aside). You can’t go wrong with that!

  11. 11. The Reverend

    cannon_fodder:

    you are correct. the pension adjustment for DB plans is

    (annual benefit accured x 9) – 600
    benefit accrued is plan specific but would something like:
    salary x accrual rate (eg 50k x 1.5%)
    pension adjustment would be 50k x 1.5% x 9 – 600 = 6150

    the calc may have changed but this is what it looked like as recently as 2002 or so.

    factor of 9 is supposed to be an average deferred annuity factor (starting at 65) over one’s working lifetime

    the PA for DC plans is just the contribution.
    PA’s reduce your RRSP room for next year.

  12. Reverend, my example of what happens with the surviving spouse is with a real life pension, my wife’s. If she were to pass away while on the pension, the surviving spouse (me) will only get 50% of the monthly payouts. I assume that various govt pensions will have different rules.

    I’ve never heard of the pension benefits guarantee fund. Does the GM employee pension have this?

    Yes, DC plans do have lower rates. I was looking at the government of NL DC plan for part time employees, and they use PH&N funds with an average MER of 0.80%.

    Thanks for pointing out some more of the differences between DC and RRSP, good to know.

  13. 13. The Reverend

    don’t forget that we’re all members of teh defined benefit pension plan commonly referred to as CPP.

  14. 14. The Reverend

    FT, i think you’ll still have the option of having 100% continuing to you if your wife was to pass away. it would just reduce the starting benefit amount. there are certain options that are mandatory i believe (in fact to not have a % continue to the spouse, i think you need the spouse to sign a consent form)

    i think all registered pension plans are covered by the pension benefit guarantee fund. there such things as non-registered plans, but these are usually top-up plans for senior executives and are not really to be compared with RRSP, DCP.

  15. I’m for define contribution pension – I like to have control over my account. AndrewP that’s great that your company matches 100% – wish I had that.

  16. 16. canucktuary

    From an actuarial perspective:
    DB plans are tax inefficient. The PA Rule of 9 is based on very generous ancillary benefits. It also penalizes younger (under 40) workers since a large chunk of the accrual is not until your years closest to retirement.

    FT – when designing a DB pension plan, the employer has the option of deciding which forms of benefit to offer. These are usually determined on an actuarially equivalent basis. I think most jurisdictions require the minimum to be Joint & Survivor 60%. That is once you die your spouse will continue receiving 60% of your benefit. This seems fair since your family will have roughly half the expenditures cut from their retirement expenses when you pass on. What may not be fair is when your employer does not off the J&S 60% as the normal form of payment, and you have to take a reduction in your pension to receive the legislated form of payment.

    Scott – you will receive the same retirement income regardless of market performance, but you and the employer both have an obligation to contributing to your pension to get you there. As a taxpayer it is unfair for us to pick up your pension deficit without you having to contribute a dime. It is up to individual employers to determine whether or not their employees should share in the cost.

    AndrewP – this is a perception that many DC plan members have. It seems really generous that the company would just double up your money, but in fact this is a lot less generous than a DB plan where the employer will put in everything, bear the investment risk, bear the inflation risk, bear the mortality risk….and you would put in nothing.

    Its a very interesting time to be a pension consultant right now….

  17. 17. cannon_fodder

    Reverend,

    You provided some great information and good points.

    However, I don’t see that a DCP is related to a DBP in terms of risk to the plan holder. From what I understand, when a company allows you to contribute to your DCP (with possible supplementation by the company, e.g matching contributions) for all intents and purposes that money is yours as it is held “in trust” by another firm. If there is a vesting period, then that comes into play, but my feeling is that the solvency of the company does not affect the DCP holdings. (Excuse me if I’m using the wrong financial/legal terms.)

    Now, if the company is faltering they may decide to reduce or stop matching contributions which may be where you were heading.

    I wish our company was using low MER funds – our choices are limited and for the most part seem to be copies of other funds – with the commensurate and additional management fees by our investment provider, Standard Life.

  18. From my understanding, many workers benefit more from a defined contribution plan, over a benefit plan. Would you agree?

  19. 19. Sampson

    I’m actually quite interested in whether readers believe one might out perform the other.

    My wife’s company offers both – and employees select which to enroll into. They have one opportunity while at the company to switch – my wife’s will be in 2 years I believe.

    As a DIY’er – I’m sorta pro defined contribution – we can hopefully build balanced (in our eyes) portfolios. However, I think it’d take some kind of growth (in the DCP) to get 70% of her final year’s income.

    On the otherhand – if she doesn’t stay with the company long enough to get 50-70% – then I believe the DCP might be better.

  20. 20. GTP

    I think that if you don’t stay with the company long enough, the DCP is superior, since you get all of that money. However, where I work, both DC and DB plans were offered when a number of people currently working there are about to retire. Those on the DB plans will have absolutely no problem at 70% salary. However, I know one man who will have to work a few more years to sort of catch up since his DC plan just didn’t cut it. He thought he would leave earlier in his career, but ended up staying the whole time. I would say case and point over the last 25 years.

    Also, I really like how my current pension plan is set up:
    0-10 years working: DC-Employee 4% salary, Employer 10% Salary
    10 years to retirement: DC Employer 4%, DB 1.5% x Salary

    The choice of plans was completely removed, but I think this is a great way to give the benefits of both plans and mitigate the risks discussed about both plans…

  21. 21. bank deals

    Can the pension fund contribution of 8.33 withdrawled if service is done for less than 6 months ?

  22. 22. The Reverend

    To simplify the debate, a vast majority of employers have stopped offering DB plans. Translation: DB plans are more expensive/risky for them (read better for you).

  23. 23. The Reverend

    cannon_fodder

    you are correct about solvency company and impact on DC vs DB plan. there’s no impact on DC other than maybe future contributions. for DB there is some risk you won’t get all of your retirement benefit. the guarantee funds will kick in at this point, however i think they are biased to protect people already retired over those still working toward retirement.

  24. 24. Sampson

    reverend,

    The bias towards those retiring is precisely one of the main reasons I’m hesitant to believe in DB plans – contribution rates have been leaping ahead for younger workers in order to fund the people retiring now.

    @GTP – interesting case example. I wonder if this scenario (of the DC employee working longer to make up the difference) is common. Since I’m on a DB, perhaps we’ll just have one spouse in each type of pension plan and take the average.

  25. 25. GTP

    Sampson -
    Seems to be the way the new plans are going, and I like the idea. The DB plan stops when you die but the DC funds will continue to grow until you need them (assuming the DB plan is enough for retirement)….

  26. In the 21st century america more and more companies are switching to defined contributions plans. The only way that investors could guarantee themselves a steady paycheck in retirement is save and invest as much as possible in dividend stocks and a little bit of real estate income and fixed income instruments.

    The main benefit of DC plans that I see is that if you manage your withdrawals carefully, you could leave a nice inheritance to your heirs. With DB plans however once you are gone, your pension is gone as well

  27. 27. Houska

    There’s discussion of whether DB or DC is more risky for the retiree. The answer is that it depends since there are two types of risk.

    One is the risk of uncertain investment performance (let’s call it market risk), leading to uncertain level and duration of payout for retirement. This is a continuous risk – you expect it to vary with a bell curve like shape (possibly with fatter tails). In a DC scheme, the retiree bears all of this risk. In a DB scheme, the employer bears the bulk of this risk, though as mentioned above, if the whole plan gets too much out of whack, contributions may need to be adjusted.

    The second is the catastrophic risk of an event wiping out (or significantly devaluing) the pension. This is a form of counterparty risk. In a DC plan with reasonable asset allocation, this is only the risk of a complete financial system failure – possible, but unlikely, and its impact is somewhat under the control over the retiree by what they do. In a DB plan, the retiree is significantly exposed to the risk of collapse of his/her employer and devaluation of the pension.

    So in DC, recipient has lots of market risk but minimal counterparty risk. Employer has none of either, so prefers it. In DB, employer bears the bulk of the market risk, but recipient has a ton of counterparty risk – financial health of the employer.

  28. 28. cannon_fodder

    If I understand correctly, many public sector DBP’s coordinate with the CPP so that you can’t “double dip”, i.e. receive the CPP without a commensurate reduction in your DBP payments.

    Is that correct?

  29. cannon, that is my understanding yes.

  30. 30. Ed Rempel

    Hi Cannon & FT,

    Yes, most public sector DBP’s are integrated with the CPP. The actual pension is benefit you calculate from the formula less an estimate for CPP.

    For example, if your formula is 2%/year x the average of your best 5 years x 30 years in the pension, you would expect to get 60% of the your salary for the 3rd year before retirement. However, that is what you would get from BOTH your pension and CPP.

    Ed

  31. 31. cannon_fodder

    Ed,

    So, do you have to annually submit any documentation to the ‘trustee’ administering your DBP detailing how much CPP you received? Or do they simply ask for a statement of contributions to coordinate the benefits?

  32. 32. Ed Rempel

    Hi Cannon,

    No. The pension administrators have a “CPP offset formula” that they use to estimate your CPP during the time you were in that pension plan.

    Most pensions offer you a choice when you retire of taking a flat pension or an integrated pension (if you retire before age 65). For example, if you retire at 55, you may have a choice of taking $25,000/year flat for life, or taking $30,000/year from age 55-64 and then it drops to $20,000/year from then on as your CPP of $10,000 kicks in.

    If you take the flat pension, then your income will actually be higher at age 65. This may make sense if you are still working part time, for example.

    Many people take the integrated pension to give themselves more travel/spending money the first few years. Then they also elect to take CPP early at age 60. Their pension will then drop by about $10,000 at age 65, but OAS still kicks in at about $6,000, so their income drop at 65 is not much.

    Ed

  33. 33. whiskey tango

    i have a nice DCP with matching at work. but my investment choices are limited and in my opinion very expensive due to management fees. Is it possible occasionally transfer money out of an RPP into a self directed LIRA without quitting my job and ending the RPP?

  34. 34. Johnny Cash

    What does the rule of age 55 and 10 years of continuous pensionable service (DB) mean in Ontario?

  35. 35. paul

    What are your thoughts on buying back service, under defined benefit plan?

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