Defined benefit pension plan

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A defined benefit pension plan is a type of pension plan in which an employer/sponsor promises a specified monthly benefit on retirement that is predetermined by a formula based on the employee's earnings history, tenure of service and age, rather than depending directly on individual investment returns. The investment risk is borne by the plan, not the beneficiary.

Over four million Canadians are covered by a defined benefit pension plan.[1]

Origins

Defined benefit (DB) pension plans can be traced to the 19th century in Canada. The federal government created a "pay-as-you-go" plan for civil servants in 1870. While their share of Registered Retirement Plans (RPPs) is declining, DB pension plans still cover 84% of RPP members. However, RPPs have never covered more than 50% of the working population.[2]

The Canada Pension Plan is an example of a defined benefit pension plan.

Types of payout

Payouts depend on the type of formula used to determine the pension benefit. There are three. In a final average plan, the pension payout is based on on the last three or five years of income. In a career average plan, the payout is based on earnings over time. Under a flat benefit plan, payouts are based on hourly wages. In each case, the payout includes years of service.

This yields the following formula: 1% x earnings x years of service. The 1% may vary. For some plans, it could be 2%, which is the maximum allowed under the Income Tax Regulations[3] (some plans would use a lower accrual rate for earnings up to the yearly maximum pensionable earnings (YMPE), which are covered by CPP as well). Earnings are variable as well: final average, lifetime average, hourly. In the latter two cases, the lifetime average or the hourly average will be boosted if there are pay increases.

This establishes the pension entitlement. The payout may be administered by the pension plan itself, outsourced to a life insurance company, or converted to an annuity – again, with a life insurance company.

Tax deductibility

A DB plan is a Registered Retirement Plan. Thus, contributions are not taxed as they go in, but as they go out. That allows for tax-free growth within the plan.

RPPs have the same tax-deferred status as Registered Retirement Savings Plans (RRSPs). Thus, there is a maximum 18% deduction up to a limit of $132,000 (for 2013). In a contributory plan, employees and employers split the tax deduction according to the proportion of their contributions. In a non-contributory plan, the tax deduction goes to the employer.

Commuted values

If you leave a company or government entity before you are eligible to retire – which is generally age 55 – there are a number of options for dealing with your accrued pension benefits. You can leave the money with the pension plan with no further service benefits. Consider it like a deferred annuity.

Or you can take the commuted value out of the pension plan and invest it yourself, in a locked-in account. This is a lump sum payment rather than a deferred annuity. But it works on the same principle, namely that you won't generally be able to access the money until your normal retirement ages.

The lump sum represents a present value calculation of how much you would have received in retirement, based on years of service. Thus, if you had 10 years of service, the lump sum is the amount you would have been expected to receive, as determined by today's long-term government bond rates.

Solvency

DB plans undergo an actuarial evaluation every three years to determine how well they are funded – in deficit, in surplus or fully funded. By law, a DB plan cannot be more than 110% funded.

The funding calculation measures the present value of pension obligations against a discount rate. The discount rate is yield on high-quality corporate bonds.

The present value of the obligations consists of accrued benefits, which will differ from one age cohort to another. These have a current value. The discount rate is used to determine whether these accrued benefits can be paid for out of current assets without further contributions.

There are two ways to evaluate a plan's funding status. The first is as a going concern. This assumes the entity will continue to operate. In many instances, assuming the past is the same as the future, pension plans will be deemed to be fully funded.

The second is solvency: if the entity were to go bankrupt today, would it be able to pay its pension obligations. On a solvency basis, plans have five years to return to full funding.

Bankruptcy

If an entity goes bankrupt, the pension plan is wound up. If it is underfunded, pensioners will see a reduction in their promised benefits. The pension plan is an unsecured creditor and thus ranks behind bondholders in on the entity's assets.

For example, when Nortel Networks entered bankruptcy in 2010, the $5 billion pension plan was underfunded by $1.5 billion. As a result, unionized workers were to receive 75% of their pension and non-unionized workers 70% of their pension.[4]

Is your DB plan enough?

Some DB plans have a formula such that you will get a pension equivalent to 70% of your final salary (or rather, an average of your last few years) after 35 years of service, taking into account integration with CPP/QPP. For example, if you start contributing at age 30, you will be eligible for a full pension at age 65. That percentage (70%) of your final salary should typically be enough to maintain your lifestyle in retirement (see replacement rates). This assumes that you will spend nearly your entire career with an employer that offers a generous pension plan, and that the pension will be fully indexed (protected against price inflation).

Consider saving additional amounts in a RRSP or TFSA, or making additional voluntary contributions to your DB plan (see next section) if:

  • You will not have 35 years of service at retirement (e.g., you started contributing late, or you spent several years off of the workforce, or you want to retire early);
  • Your DB plan will replace much less than 70% of your final salary even after 35 years of service;
  • Your pension will not be indexed, or will only be partially indexed;
  • Your DB plan is severely under-funded or your employer is near bankruptcy and you are unsure that you will get the full pension you theoretically deserve;
  • You might not spend your entire career with the same employer and the next one may not offer a DB pension plan;
  • You have ambitious goals for your retirement.[5]

Additional voluntary contributions

Some DB plans allow members to make additional voluntary contributions (AVCs). One example of a DC plan offering AVCs is OMERS. AVCs are meant to replace, or complement, individual RRSPs, and count toward your annual RRSP limit. Contributions are typically invested in the same pool of money as the rest of DB plan funds (same asset allocation, same managers, etc.). But the additional income you will get at retirement is not based on a formula (like is the case for for your regular contributions). Instead, AVC accounts earn the actual return of the pension assets every year. Upon retirement, choices may include (e.g., [6][7]):

  • keeping the money in the AVC account (with a right to make withdrawals);
  • transferring your money as a lump sum to a RRSP;
  • buying an additional monthly pension (to be paid by your pension plan) based on prevailing interest rates;
  • buying an annuity from an insurance company.

Advantages

  • Professional management of investment funds
  • Wide diversification (perhaps including infrastructure, directly held real estate, private equity, etc.)
  • Reasonable fees, typically less than 1%, i.e. cheaper than most mutual funds (e.g., [7][8][9])
  • If contributions are made regularly through payroll deduction, income tax will be immediately reduced (e.g., [8])
  • Some plans offer fully indexed pensions upon retirement

Disadvantages

  • Asset allocation is based on the long term objectives of the whole DB plan, and may be too aggressive (immediate pre-retirement years and post-retirement years), or not aggressive enough for some young investors[8]
  • There may only be a limited time window to convert your AVC account to a monthly pension (with a RRSP, if prevailing interest rates are low, you can wait and buy an annuity later); check your specific plan for details and options
  • You might prefer to manage your RRSP yourself if you have a history of beating or matching your DB plan returns
  • There is no equivalent to spousal RRSPs, which allow income splitting, or to the Home Buyers' or Lifelong Learning Plans[10]

See also

References

  1. Statistics Canada, Registered pension plan (RPP) members, by area of employment, sector, type of plan and contributory status, viewed February 18, 2017
  2. Association of Canadian Pension Management, Delivering the Potential of DC Retirement Savings Plans, May 2008, p. 6.
  3. Canada Revenue Agency, Registered Pension Plans Glossary, Benefit accrual rate, viewed February 18, 2017
  4. Wikipedia, Nortel Retirees and former employees Protection Canada, retrieved December 16, 2013.
  5. Bruce Sellery, Is a pension enough?, MoneySense, December 10th, 2012, viewed March 17, 2017
  6. OMERS, AVCs -- Withdrawal Options, viewed March 6, 2017
  7. 7.0 7.1 RRUQ, Les cotisations volontaires, viewed March 6, 2017
  8. 8.0 8.1 8.2 Queen's University Pension Plan, Additional Voluntary Contributions (AVCs) and your RRSP, viewed March 6, 2017
  9. OMERS AVCs, Fees & Expenses, viewed March 6, 2017
  10. Bruce Cohen, Re: Additional Voluntary Contributions to OMERS?, Financial Wisdom Forum post, January 27, 2011, viewed March 6, 2017

Further reading

External links