Defined benefit vs defined contribution pension plans – who wins?

BY ANDREW STEWART

Sometimes I wonder why we make simple concepts more convoluted and confusing that it should be. A simple idea of helping employees save money for retirement and with the hopes of retaining top talent has become a little bit of a brain scratcher to most people. I can recall the first time I got a job with a pension benefit; I just kept hearing from my parents and other employees that it was a good thing to have.

When I get inspired to write about a topic, I choose so it applies to everyone. I want all my readers to be able to get something out of my article, whether it applies to them today or maybe in the future. Today I want to talk about what the difference is between a defined benefit pension plan and a defined contribution pension plan. Even if you don’t have access to one of these two types of pensions, it’s important to have some idea of how they work just in case you get access to one in the future. If you are among the approximately 38% of Canadians who have a pension plan through their employers count yourself lucky. Pensions help you go towards meeting your retirement saving goals and see what other additional planning and saving you may need to do.

A defined benefit pension plan is a retirement account for which your employer ponies up all the money and promises you a set payout when you retire. The formula used to determine your yearly payout is usually years of service multiplied by a percentage of your yearly salary. As a simple example to help illustrate how this could work, lets say:

Ray served 30 years working for Nike and made an average of $75,000 in his final 5 years of working. Ray would see the following payout when he either left the company of retired.

30 X $1,500 (2% of $75,000) =$45,000 per year when retired

This is strictly a generalization since every pension formula is different, but you can see how valuable a defined benefit pension plan can be. Since the employer is responsible for the payouts, all the risk lands on them. They need to make sure that the plan is well funded and that the assets held are enough to make yearly payouts for everyone collecting.

A defined contribution pension plan requires you to put in your own money. You know how much you are putting in (the defined contribution part), but not how much you will take out. With a defined contribution pension plan, your employer will usually match a certain amount when you contribute to a group RRSP plan. Your plan administrator gives you a list of investment options to choose from, typically, mutual funds, stocks and bonds and you decide according to your own investment goals and tolerance for risk. The responsibility for investing wisely is yours, rather than your employer’s.

In both cases, you just show up for work and, assuming you meet basic eligibility rules and you’re automatically enrolled in the plan. Now if the rules just stopped there that would be great, but like I said it’s not that simple. You also need to stick around on the job for several years in order to take that money with you. Typically, it’s a minimum of 5 years to be fully “vested” in the plan. If you leave before the benefits vest, you will receive only the value of your own contributions and earnings.

So, what happens when you retire or leave when your plan if it’s fully vested?

While a defined benefit pension plan pays you directly, you must convert a defined contribution pension plan to an income-generating product such as a life income fund (LIF) or an annuity to get a regular income from it. You may be allowed to keep your investments in the plan you’re exiting or transfer your commuted value to a locked in RRSP or another pension plan.

Final thoughts: When looking at defined benefit vs defined contribution pension plans, clearly the defined benefit plan comes out on top. Either way it’s extra money earned and should be thought about wisely.