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Defined benefit pension plan

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Retirement planning
(pensions)
Pension plans
Government retirement benefits

A defined benefit pension plan is a type of pension plan in which the sponsor promises a specified monthly benefit on retirement. The sponsor can be an employer, group of employers, or union.[1] The retirement pension is determined by a formula based on the employee's earnings history, tenure of service and age, rather than depending directly on investment returns: the investment risk is borne by the plan, not the beneficiary.

There is one pool of assets for all members[1] in which contributions from active members are deposited and from which pensions of retired members are paid out. The sponsor is responsible for making sure the assets are large enough to cover the liabilities, i.e. pay the promised pensions.[1] Actuaries regularly check that this is the case. If there is a deficit, the sponsor must top up the plan within a certain timeframe.[1]

Over 4.5 million Canadians are covered by a defined benefit pension plan.[2]

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 68% of RPP members.[2] However, RPPs have never covered more than 50% of the working population.[3]

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.[1][4] In a final average plan, the pension payout is based 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[5] (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.[citation needed]

CPP/QPP integration

Many DB plans are designed to pay more before the age of 65, at which time the worker is assumed to start claiming Canada Pension Plan or Québec Pension Plan. Then, starting at age 65, the DB benefits are "integrated", i.e. reduced, by an amount equivalent to CPP/QPP, regardless of when CPP/QPP are actually claimed.

For example, in a 2% per year of service, final average salary DB plan, the retiree would get a pension equivalent 70% of final salary (3-5 year average) after 35 years of service. Suppose that retirement happens at age 63. After two years, at age 65, the DB pension would be reduced, but that can be compensated by claiming CPP/QPP then, to get the same 70% replacement rate. If the retiree instead wants to wait to claim CPP/QPP, to get a higher monthly amount, some personal savings will have to be consumed to bridge the gap.

Your annual report from your DB plan will present your accrued pension before, and after, integration.

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.

Maximum pension

Unlike for Registered Retirement Savings Plans (RRSPs) and defined contribution pension plans, the maximum contribution is not expressed as a yearly maximum of money added to the plan. Instead, the law limits the total accrued pension to:[6]

DB limit * years of service

For example, in 2025, the maximum yearly DB pension that someone is entitled to (at retirement) after 10 years of service is:

$3,756.67[7] * 10 = $37,567

Also,

DB limit = 1/9 MP limit[7]

where the money purchase (MP) limit is the maximum dollar contribution in a DC plan, indexed every year. The factor 9 comes from actuarial calculations made in the 1980s and "postulates that financing an annuity equal to 1 percent of earnings requires saving 9 percent of earnings each year over a 35-year career".[8] For a pension equivalent to 2% of salary per year of service (the maximum accrual per year in a DB plan), one would need to save 18% of earnings (the RRSP and DC plan limit) over 35 years.

For details, see Income Tax Act (Regulations S. 8504).[9]

Pension adjustment

The factor 9 also comes up in the Pension adjustment, which reduces your Registered Retirement Savings Plan (RRSP) deduction limit for the following year. DB plan members see next year's RRSP contribution limit reduced by 9 times the pension earned (accrued) this year, minus $600.[8][10] Leaving aside the $600 amount, from the fiscal authority's point of view, a RRSP limit of 18% of earned income (up to a maximum) is supposed to be equivalent to the right to earn a DB pension of 2% of salary per year of service (up to a maximum).[6]

Leaving your employer

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.[4] You can leave the money with the pension plan with no further service benefits. Consider it like a deferred annuity: the pension will start later (at retirement).

Another option is transferring the pension to another DB pension plan, if the new employer accepts it.

Finally, 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 at least every three years to determine how well they are funded – in deficit, in surplus or fully funded.[1] By law, a DB plan cannot be more than 110% funded.[citation needed]

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.[citation needed] 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.[4] If it is underfunded, pensioners may see a reduction in their promised benefits.[4]

Current law

The pension plan is an unsecured creditor and thus ranks behind bondholders in on the entity's assets.[11][12]

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.[13]

Super priority from 2027

From April 27, 2027, in case of bankruptcy of a plan that existed before April 27, 2023, the Pension Protection Act (Bill C-228) will give "super priority" to DB plan funding deficits.[11][12] For plans created after April 27, 2023, the new priority already applies.

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.[14]

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., [15][16]):

  • 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., [16][17][18])
  • If contributions are made regularly through payroll deduction, income tax will be immediately reduced (e.g., [17])
  • Some plans offer fully indexed pensions (inflation-indexed annuities) upon retirement; those are typically not offered to the general public by life insurance companies

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[17]
  • 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[19]

See also

References

  1. ^ a b c d e f Cohen B, Fitzgerald B (2007) The Pension Puzzle, Wiley, ISBN 978-0470839539, Chapter 7: Defined Benefit Plans: Promises, Promises.
  2. ^ a b Statistics Canada, Registered pension plan (RPP) active members by area of employment, table 11-10-0133-01, viewed June 15, 2025.
  3. ^ Association of Canadian Pension Management, Delivering the Potential of DC Retirement Savings Plans, May 2008, p. 6.
  4. ^ a b c d Ontario Securities Commission, How defined benefit pension plans work, viewed January 4, 2026.
  5. ^ Canada Revenue Agency, Registered Pension Plans Glossary, Benefit accrual rate, viewed June 22, 2025.
  6. ^ a b Marc Bachand, Nicolas Lemelin, Nicolas Boivin, Donnez un sens à vos finances 2024-25, viewed June 14, 2025.
  7. ^ a b Canada Revenue Agency, MP, DB, RRSP, DPSP, ALDA, TFSA limits, YMPE and the YAMPE, viewed June 14, 2025.
  8. ^ a b Robson WPB (2017) Rethinking Limits on Tax-Deferred Retirement Savings in Canada, CD Howe Institute Commentary No. 495, 20 p, viewed June 22, 2025.
  9. ^ Government of Canada, Income Tax Regulations (C.R.C., c. 945), viewed June 20, 2025.
  10. ^ University of British Columbia, RRSP Contributions & Pension Adjustments, viewed June 20, 2025.
  11. ^ a b Borden Ladner Gervais LLPBill C-228: Expanded pension protection receives royal assent, July 10, 2023, viewed January 4, 2026.
  12. ^ a b Miller Thomson, Bill C-228 and defined benefit pension plans, April 27, 2023, viewed January 4, 2026.
  13. ^ Wikipedia, Nortel Retirees and former employees Protection Canada, retrieved December 16, 2013.
  14. ^ Bruce Sellery, Is a pension enough?, MoneySense, December 10th, 2012, viewed March 17, 2017
  15. ^ OMERS, AVCs -- Withdrawal Options, viewed March 6, 2017
  16. ^ a b RRUQ, Les cotisations volontaires, viewed March 6, 2017
  17. ^ a b c Queen's University Pension Plan, Additional Voluntary Contributions (AVCs) and your RRSP, viewed March 6, 2017
  18. ^ OMERS AVCs, Fees & Expenses, viewed March 6, 2017
  19. ^ Bruce Cohen, Re: Additional Voluntary Contributions to OMERS?, Financial Wisdom Forum post, January 27, 2011, viewed March 6, 2017

Further reading

External links

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