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Pension Basics: Defined Benefit Pension Plan Payout Formulas



If you have a defined benefit (DB) pension plan, it’s important to understand your plan formula. DB pension plans are a lot more complicated than Defined Contribution (DC) pension plans. Here is a typical DB plan formula:

2% x your average salary in the last 3 years x your years of plan membership = your annual pension

For example:

2% x [($75,000 + $76,000 + $77,000)/3 years] x 30 years = $45,600 per year or $3,800 per month

Unfortunately, very few DB plans are this simple. It should be easy enough to find your plan formula – look in your pension booklet or ask your Human Resources department. It’s important to know the type of DB plan your employer offers – it can mean the difference between receiving a monthly pension of $500 and $2,500 with the same salary.

Final Average Earnings (FAE) Plan

Your pension is based on your years of plan membership and your average earnings for a specified period before retirement. The most common are FAE3 (average of your last 3 years of earnings) and FAE5 (average of your last 5 years of earnings). FAE plans are beneficial because your salary is typically at its highest right before retirement.

FAE3 Example:

1.3% x [($70,000 + $71,000 + $72,000)/3 years] x 10 years = $9,230 per year or $769.17 per month

FAE5 Example:

1.3% x [($68,000 + $69,000 + $70,000 + $71,000 + $72,000)/5 years] x 10 years = $9,100 per year or $758.33 per month

As you can see, FAE3 plans usually result in a higher pension. The only exception is if your salary decreases right before retirement.

Career Average Earnings (CAE) Plan

Unlike a FAE plan where only your final 3 years or 5 years of salary are used, in a CAE plan your pension is based on your average salary spanning your career. If you’ve been with your employer for many years and moved up salary bands, you could end up with a significantly lower pension than under a FAE plan.

CAE Example:

1.3% x [($63,000 + $64,000 + $65,000 + $66,000 + $67,000 + $68,000 + $69,000 + $70,000 + $71,000 + $72,000)/10 years] x 10 years = $8,775 per year or $731.25

As you can see, the annual pension is a lot lower ($8,775 CAE vs. $9,230 under FAE5) since more years of lower earnings are included. Employers are increasingly switching from FAE plans to CAE plans for greater cost certainty. Some employers update your earnings to account for inflation, although it’s very rare.

Best Average Earnings (BAE) Plan

BAE plans are the cream of the crop. BAE is very similar to FAE with one major exception  – your highest years of salary from any time spanning your entire career are used to determine your pension, even if they weren’t in your years preceding retirement. In most cases you’ll end up with the same pension as a FAE plan. However, if you work a reduced work week before retirement or you’re a commissioned salesperson whose best years were before retirement, you won’t be penalized with a lower pension.

BAE3 Example:

Year Earnings

2003

$63,000

2004

$64,000

2005

$82,000

2006

$80,000

2007

$81,000

2008

$68,000

2009

$69,000

2010

$70,000

2011

$71,000

2012

$72,000

The employee’s highest years of earnings were in 2005, 2006 and 2007. We use these earnings to determine his monthly pension.

1.3% x [($82,000 + $80,000 + $81,000)/3 years] x 10 years = $10,530 per year or $877.50 per month

As you can see, the annual pension is a lot higher than if a FAE or CAE plan formula were used. If you have a BAE plan consider yourself lucky – very few employers offer them today.

Flat Dollar Plan

In a flat dollar pension plan your salary is not used to determine your pension. Instead your pension is based on a set dollar amount times your years of credited service. It’s the simplest plan formula and generally, the least generous. It’s mostly found in unionized workplaces. Unions typically negotiate an increase in the flat benefit amount when the collective bargaining agreement is up for renewal.

Flat Benefit Example:

$25 x 12 months x 10 years = $3,000 per year or $250 per month

Final thoughts

As you can see, the type of pension plan you have can have a big impact on the pension you receive at retirement. If you’re thinking about working a reduced workweek before retirement, it’s important to consider how it could affect your pension.

Do you know which type of pension plan your employer offers? Do you know your pension plan formula?

About the AuthorSean Cooper is a single, 20-something year old, first time home buyer located in Toronto. He has experience in the financial sector as a Pension Analyst, RESP administrator and Income Tax Preparer. He holds a Bachelor of Commerce in business management from Ryerson University. You can read some of his other articles here.





6 Comments, Comment or Ping

  1. Even more important than the formula for your starting monthly pension is the inflation indexing rules. Some members of my extended family have pensions that are now nearly worthless because the payments weren’t indexed.

  2. 2. Ed Rempel

    Hi Sean,

    Good article. There are 2 key reasons why pension payments are usually quite a bit less than you calculate from the formula:

    1. Most Defined Benefit pensions are “integrated with CPP”. That means that the pension you calculated is what you get in total from BOTH your pension plus CPP.

    There is a CPP-offset formula that subtracts an estimate of your CPP benefit from the pension benefit.

    2. Spouse survivor benefit – If you are married, your pension will be reduced by the spousal survivor benefit, which is usually a reduction of 5% to 10%. If your spouse outlives you, then he/she will get 60% or so of your pension. This 5-10% reduction is what pays for this benefit. The amount of this reduction depends on whether your spouse is male or female and your spouse’s age relative to yours. A larger reduction will apply if your spouse if female and younger.

    Ed

  3. Great points, guys!

    @Michael James
    Pension indexation can be complicated. For example, at Canada Post you only receive an annual indexation increase if the CPI increases at least 2%, meaning that if it doesn’t you get zilch! Some pension plans only provide 75% or less of the CPI increase, so you need to read the fine print.

    @Ed
    You’re right about the CPP-offset – it can have a huge negative impact on your pension. For example, I prepared a retirement package for a lady who had worked at a company for 30 years and was earning $70,000 at retirement. If it wasn’t for the CPP Offset she probably would have received at least $2,000 a month – instead she only received $500 per month. Talk about crummy!

    A lot of members just select 100% Joint & Survivor without thinking – even males who are 20 years older than their spouses. If both spouses have a decent pension it probably makes sense to take a life only pension and take the higher amount, unless one of the spouses is sick and dying.

  4. I have only been elegible for the pension offered through my employer for 1 year. The amount that my employer and myself contribute to the pension is only $1500 per year. I am in my late 40s so my pension is not going to amount to much.

    I am considering withdrawing the entire amount of the pension in a year before my government pension starts and use that as my only income in 1 year. There will probably less than $20,000 in the account so I should not take too much of a tax hit.

  5. 5. Reginald

    1. is the CPP-offset also referred to the “bridge benefit”? The benefit that is only given between the time you retire (if before age 65) and become eligible for CPP?
    2. defined benefit plan vs RRSP: what about the issue of legacy? From my rough calculation it seems with DBP that your pension comes from the yearly interest/growth of the pool of money you saved and grew during your career, ie. each year you get approx 5% of your pool (but that is also the goal of RRSP eg 4% rule). The difference being that with DB once you die your estate loses the pool (assuming no spouse), but with RRSP the estates gets the pool (less taxes). so the main pro of DBP is the guarantee of the pension? could you not get a similar pool in you RRSP with proper investing?

  6. @Reginald
    1. Yes, they are the same. A bridge benefit (formerly referred to as the CPP offset) is a temporary benefit, payable until age 65 (the bridge benefit stops if you become entitled to CPP/QPP disability benefits). Regardless of when you start your CPP/QPP pension, your bridge benefit payments will stop at age 65.

    2. Think of a defined benefit pension like an annuity. If you live to be 100 the insurance company has to pay you until 100. If you live until 70, you’re out of luck, unless you elected a joint & survivor pension. If you’re really worried about passing away young, you can always terminate your employment and take the commuted value and invest the money yourself. That way your estate would be guaranteed something.

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