Pension Plans are the Foundation of Retirement Planning

According to Canada Customs Revenue Agency (CCRA), “A pension plan may generally be described as an arrangement between an employer and its employees, or between a union and its members, for providing pension benefits to the employees or the union members on retirement. Pension plans are regulated by federal and/or provincial legislation.”

Although there are many types of pension plans, there is at least three main elements in a pension plan arrangement: the plan sponsor or the employer, the plan itself, and the funding medium or the “Fund”.

Different types of pension plans

Pension plans can vary greatly in terms of their structure and the benefits they provide. The two most common types of pension plans are the defined benefit plan and the defined contribution (or money purchase) plan. Some employers offer a combination of the two types of plans – known as “hybrid” or “combination” plans.

The first thing we need to do is distinguish between the two basic types of pension plans:

1. Defined Benefit Plan

Under the defined benefit plan, the known element is your pension benefit at retirement. This benefit is usually expressed by three variables:

  1. Number of years you worked for the company
  2. Your salary (it is usually an average of a number of years)
  3. A predetermined factor like 1% to 2%

The employee contribution is often a fixed percentage of salary, up to a maximum. Contributions required from the employer are usually determined by actuarial calculations and may be subject to fluctuation caused by market and experience risk. If, however, the plan is terminated, the employer is responsible only for those funding payments, which are due at the time of termination and are not required to fund any shortfalls on wind-up.

Let’s say Monica worked for her employer for 18 years and her pension plan offered a 2% benefit and her last 5 years of salary averaged $53,000/yr. In this example, Monica’s pension would be $19,080 per year (18 X 2% X $53,000). The unknown element is the amount of money that is going into the pension plan to create this income. Typically, the employer bears the funding risk.

2. Defined Contribution Plan

Under the defined contribution plan, the future benefit is the unknown. The future benefit depends on how much money is put into the plan by the employer, the employee and the rate of return earned by the investments. What is ‘defined’ in this plan is the amount of contributions that will be put into the plan. This is usually expressed as a percentage of income. Employees bear the market risk and, provided that contributions are remitted in a timely fashion, defined contribution plans are, by definition, always fully funded.

For example, Chandler is earning $45,000 per year and under his pension plan, he will contribute 2% of his income to the plan and his employer will put in 4%. In this example, Chandler will have a deduction of $75 per month going to the pension plan and his employer will be putting in $150 per month for a total of $225 per month. His benefit at retirement will depend on how much he puts in, for how long and the rate of return his investments earn in the pension.

Some defined contribution plans permit employees to make their own investment choices, while others provide that the employer or a board of trustees is responsible for all investment decisions.

How does this apply to you?

The trends in Canada are simple. First is that there will be fewer people collecting pension income in the future. Consider that according to Canada Customs Revenue Agency (CCRA), 56% of seniors receive some type of pension income. Only 40% of the workforce currently belongs to a pension plan.

The second is there is a trend to replace defined benefit plans with defined contribution plans. It is pretty clear that individuals need to take control of their retirement planning. Fewer employers want to bear the risk of defined benefit plans making RRSPs more important to most Canadians.

If you are part of a pension plan, your pension will likely be the cornerstone of your retirement income planning. It is imperative that you know what kind of pension plan you belong to and how much income your pension is likely to give you in retirement.

Written by Jim Yih

Jim Yih is a Fee Only Advisor, Best Selling Author, and Financial Speaker on wealth, retirement and personal finance. Currently, Jim specializes in putting Financial Education programs into the workplace.For more information you can follow him on Twitter @JimYih or visit his other websites Group Benefits Online and Advisor Think Box.

One Response to Pension Plans are the Foundation of Retirement Planning

  1. randy says:

    Is there way to get some funds out of Lri fund
    In ont set up by wsib i am injured worker
    And have alot in the fund

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