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
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.
1.3% x [($70,000 + $71,000 + $72,000)/3 years] x 10 years = $9,230 per year or $769.17 per month
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.
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.
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
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 Author: Sean 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.If you would like to read more articles like this, you can sign up for my free weekly money tips newsletter below (we will never spam you).