What You Need to Know About Defined Benefit Pension Plans

Planning for retirement is one of the most important aspects of financial planning and wealth management. When possible, saving and investing is a necessary and inevitable step for building a nest egg – at least one that can make retirement more comfortable.  

Saving or investing, fortunately, aren’t the only options. Workers here have employer-sponsored plans like the defined benefit pension plans in Canada to better your chances at a comfortable retirement.

So, for retirement planning, is the defined benefit pension any good? What are defined benefit pension plans? Exactly how does a defined benefit pension work? In this article, Benefits and Pensions Monitor sheds some light on these and more questions you might have about defined benefit pension plans in Canada.

Defined benefit pension plans: an overview

For comparison, workers in North America have an employer-sponsored retirement savings plan commonly called the 401(k). Meanwhile in Canada, one of the types of pension plans available is the employer-sponsored defined benefit pension plan. This retirement plan can also go by other names like pension plans or qualified benefit plans.

It’s called a “defined benefit” plan as both the employer and their employees already know how to compute for their retirement benefits even before their retirement, and they can use it to define and determine the benefit. While it may bear some similarities to, say, the American 401(k), the Canadian defined benefit pension plan is quite different, and can even vary from province to province.

Here are some key points to remember about the Canadian defined benefit pension plan:

• a defined benefit pension plan guarantees plan members receive a specific amount of monthly retirement income when they reach retirement age
• there is more than one formula that can be used to determine how much you contribute to a defined benefit pension plan
• formulas used to compute the benefit often use factors like number of years of service and average salary earned for the duration of your service in the company
• employers in Canada are required to contribute at least 50% of the pension benefits you earn
• even if you leave a defined benefit pension plan before your retirement, you still have options

What are the rules for a defined benefit pension plan?

As with many types of pension plans, the defined benefit pension plan in Canada has its own set of rules. These rules cover items such as:

• what the benefits are
• who sets the terms
• membership in the plan
• who contributes to the plan
• how the terms of the plan are regulated

Run down the list below to see how the defined benefit pension plan works in Canada.

How do you participate in a defined benefit pension plan?

Membership in a defined benefit pension plan can be as simple as getting hired in the company. In most instances, the employer gets to decide whether an employee gets to participate in their defined benefit pension plan.

The cost of entry is often not complicated or difficult; sometimes all it takes is to stay in the company for at least two years, and/or the employer will offer you the chance of opting in. Sometimes, you are allowed to participate in the pension plan on day one of your employment.

There are also employers in Canada that grant membership into the defined benefit pension plan to part-time workers. Check with your employer’s plan administrator if this is the case.

In Ontario, for example, you could join the defined benefit pension plan if you worked at your employer for 24 months straight, and:

• you have worked at least 700 hours a year for the two previous calendar years, consecutively
• you have earned $18,000 or more in each of the two previous calendar years

Defined benefit plans provide a pension that is funded in part by your employer, so it’s best to join the plan as soon you can — even if making contributions is mandatory.

How are contributions to a defined benefit pension plan calculated?

The standard practice is that your employer contributes to your defined contribution plan. Here are a few important items to remember when it comes to the plan:

• contributions are based on a percentage of your salary
• these contributions have the dual advantage of being tax-deductible and paid towards your pension
• your employer may raise or lower the employee contribution rate – this will depend largely on the terms of the plan, and the agreed funding requirements
• funding requirements are determined by actuaries who evaluate the plan periodically, usually every three years
• your employer also contributes to the plan and is obliged to fund at least half of the pension benefits you earn

There are some plans that require you to be a plan member for a specified time before you are entitled to the plan benefits. This is called vesting. The length of time can vary by province or region.

What happens to a defined benefit pension plan if you quit?

When you leave your job, you may want to move your defined-benefit (DB) pension away from your employer and into a different financial institution that your employer has no control over. However, that’s one of the options you have for your DB pension plan. Here’s what you can do:

Option 1: Leave the plan with your former company

Basically, you do nothing and simply leave the plan as is, where is. If you go this route, your retirement benefit remains in the company and will continue to appreciate – if the company makes good investment decisions, and the economy and markets perform well.

Should you choose this option, ask the pension plan administrator if there are increased administration fees. Some companies will no longer give you the discounted rate for all plan employees.

Option 2: Create a mirror annuity

The copycat or mirror annuity is another popular choice for employees coming out of a defined-benefits pension plan. This route allows you to receive the same pension that your employer promised you, but it gets paid out by a secure Canadian insurer instead of the company you worked for.

How it works is that insurance firms like Sun Life, Canada Life and Desjardins will make bids to handle your pension. The Canadian insurance company you choose will pay you the same pension, the same bridge and even the same spousal pension. In some cases, if your company’s pension has a surplus, your chosen insurance company may pay you your pension plus some extra cash.

Option 3: Withdraw the money

You can take the money out of your former employer’s DB plan. The amount you withdraw is called the commuted value. Doing this means that you opt to self-manage your pension fund.

Here's how it works:

Your employer issues 2 different cheques to you. One is locked-in pension money, the other in cash.

This money is subject to government taxes, but beyond that, the money is yours to use as you see fit. You can use it for your retirement, to pay off your mortgage, to buy a boat or an RV. You can even go on a trip. The rest is your estate.

If you choose this option, contact a financial advisor to help you invest your funds. You’ll want to have enough money to last you for the rest of your life. It’s important to have enough money in your golden years, as the money you have in retirement can impact your overall health.

You can also benefit from your CPP and Old Age Security (OAS). A good way to leverage all these retirement funds is to time their distributions. Watch this video to learn more:

How are your defined benefit pension plan pensions calculated?

Pension calculations are unique to each defined benefit (DB) plan. Generally, there are 3 common formulas, but there can be many variations. Here are the common ways DB earnings can be computed:

1. Final average earnings

This formula is based on your average earnings in the years leading up to retirement, as in the last five years before retirement, for example. Consider the formula below. It’s calculated using 2% multiplied by your average salary in the past five years. The resulting value is then multiplied by the years you participated as a plan member. So, assuming your average salary was $40,000 and you participated in the plan for 35 years your pension would be:

2. Flat benefit

In this setup, your monthly pension is simply a fixed amount for each year you were a member of the plan. A possible formula for this can be assuming your benefit amount was $600 multiplied by 35 years as a plan member. So, in this defined benefit pension plan example we use this formula, and the pension would be:

$600 x 35 = $21,000 annually

3. Average career earnings

In this computation, the pension is based on your average salary during your years of being a member in the DB plan. For example, if your average career earnings were $36,000, with a benefit percentage of 2%, and you were a plan member for 35 years, then your pension would be calculated this way:

How is the defined benefit pension plan paid out?

In general, you get a monthly payment upon your retirement from your employer. This money is given to you until you pass away. Typically, both you and your employer contribute to the plan, and your contributions are pooled into a fund. Your employer or a pension plan administrator invests and manages the fund, freeing you from making any investment choices.

The income you receive monthly is often computed based on certain factors, such as your salary and the number of years you contributed to the plan. There may be some DB plans that increase the monthly amount in proportion to increase inflation to cover living expenses – this is possible only for what’s called an indexed pension.

The Canada pension plan (CPP), defined benefits pension plan in Canada and personal pension plan (PPP) are retirement vehicles that are good for everyone – even for high-net-worth individuals.

Regardless of your present or future financial situation, managing your pension plans is crucial. This includes putting in as much as you can in your retirement account, contributing to your employer-sponsored plan, and making the right decisions with your pension plan if you lose or quit your job.

You wouldn’t want to forget your pension plan money in former employers and join the many Canadians who lost their pension money.

The defined benefit pension plan is but one of the many options for retirement planning. Get to know more about the other pension plans on our pages.