Money is only a tool. It will take you wherever you wish, but it will not replace you as the driver. – Ayn Rand
Recently, I read a great article by Rob Carrick in the Globe and Mail. It raised some major concerns about how both employees and employers perceive their Defined Contribution pension plans and the benefits they provide to members. It also stressed how important it is for employees and employers to understand how their plan works and what benefits they can expect it to provide at retirement.
Carrick’s observations mirror my own experiences of meeting with plan members and answering their questions over the phone and via email. Many plan members assume that being part of a pension plan assures them of a guaranteed income for life once they reach retirement age. Going hand in hand with this belief is the assumption that the amount they’re entitled to receive will be enough to replace their employment income in retirement. However, the reality of what they’re entitled to doesn’t always match those expectations.
If you are a member of a company pension plan, here are 5 questions that you should ask in order to understand your plan a little better:
1. Defined Benefit or Defined Contribution?
The two most common types of pension plan in Canada are Defined Benefit (DB) and Defined Contribution (DC) plans.
Defined Benefit plans provide a guaranteed income for life and the amount you are entitled to is usually calculated based on a formula that uses your years of service and highest average salary.
For DB plans, it is the benefit you receive in retirement that is defined. Your contributions and your employer’s contributions are an important part of accumulating that benefit but it’s the employer’s responsibility to make sure that the money inside the plan is invested in a way that will generate the guaranteed amount of retirement income for plan members. If interest rates fall or the stock market returns aren’t as high as expected, it’s the employer’s responsibility to fill the gap, not the members’. This can make DB plans a huge expense for employers and is one of the main reasons that many companies offer Defined Contribution plans instead.
With Defined Contribution plans, it’s the amount that is contributed by the employer and the plan members that is defined. Some plans don’t require members to contribute and are entirely funded by the employer but the most common plan design is for both the employer and the plan member to contribute.
The benefits members receive once they reach retirement age are entirely dependent on how much money was contributed to their pension account, how that money was invested and how those investments performed over time.
Related Article: Defined Benefit Pensions vs Defined Contribution Pensions
2. How Much is Being Contributed?
The most common misunderstanding that I get from DC plan members, is the belief that, because they’re part of a pension plan, they’re guaranteed an income in retirement that will be close to what they earned while they were working. They don’t realize that it’s the value of their pension account, not their years of service or salary that determines what their income will be.
Too many plan members assume that it’s their employer’s responsibility to make sure they have an acceptable amount of income once they reach retirement age and they don’t realize that, with a DC plan, that responsibility actually falls on them. Even with a DB plan, where you know how much you’ll receive in retirement, plan members still have a responsibility to make sure that amount (combined with their government benefits) will be enough and to save more on their own if it isn’t.
Even with a DB plan, where you know how much you’ll receive in retirement, plan members still have a responsibility to make sure that amount (combined with their government benefits) will be enough and to save more on their own if it isn’t.
Most personal finance experts suggest that we need to save at least 10% of our gross earnings throughout our working years in order to have enough in retirement. While ‘enough’ can vary dramatically in value from person to person, I’ve never heard anyone complain about saving too much which leads me to believe that 10% isn’t a bad benchmark to work with. However, if you have the ability to save more, then go for it!
Too often though, the amount that people contribute to their DC plans is based on the percentage that will be matched by their employer. If the employer will match 5% they’ll contribute 5% of their earnings but if the employer will only match 2% then they will also contribute 2%. In Canada, the average match offered by group retirement plans is 4%. Many plans offer a tiered match where employees have a lower matching rate in their early years of plan membership and are then entitled to a higher rate of matching as their years of service increase. Based on this information, it’s fair to assume that many DC plan members are contributing much less than they need to in order to create an acceptable amount of income in retirement.
If you’re a member of a DC plan, then you owe it to yourself to verify what percentage of your earnings is being contributed to the plan. If the total amount being contributed (your contributions + your employer’s) is less than 10% of your gross earnings, then you might want to consider either making additional voluntary contributions (if your plan permits this) or putting away extra in an RRSP to make sure you have enough in retirement.
3. Who Makes the Investment Decisions?
Most Defined Contribution pension plans put the responsibility for making investment decisions on the plan
members rather than the employer. If members don’t give investment directions for their money, the contributions to their pension account are invested according to the default investment directions for the plan.
If the default investment is an asset allocation or target date fund, then your account is still likely to
generate a reasonable rate of return over time. However, if the default is a guaranteed interest account, a money market or a deposit fund then you should consider making a change. Many pension plans with these types of defaults, were set up when interest rates were much higher and cash accounts could earn 4-5% per year. However, as interest rates have fallen over the past few years, it’s not uncommon to see members earning less than 1% per year on their money.
This rate of return isn’t anywhere near enough to create a reasonable income in retirement and that is why recent pension reforms in Alberta and BC made it mandatory for pension plans to select a balanced fund or target date fund for the plan default. However, this isn’t the case for all plans in Canada and, even when a pension plan changes its default fund, the change often only applies to new money going into the plan, it doesn’t affect money invested prior to the change.
Related Article: Where are Interest Rates Going?
4. What’s My Rate of Return?
A Benefits Canada survey of 1,008 pension plan members, asked what rate of return plan members expected to see on their investments. The average rate of return that the surveyed members expected was 17.3%. This “disturbingly optimistic” expectation was, for me, the most worrying part of Carrick’s article. Even though the median expectation was 7% per year, if we assume that this is the net return (after investment fees are deducted) that still requires an average gross return of 9-10%. This isn’t impossible but it’s a long way from the net returns of 5-6% that many experts are currently projecting over the long-term.
When I run retirement income projections for plan members, I usually use a net return of 5% on the high end and 3% on the low end to give members an idea of what they can expect their account to be worth at age 60 or 65, assuming that they continue to make the same level of contributions until retirement. If the plan has low investment fees (less than 1.5%) I might run the projections using a 6% or 6.5% return on the high end but it’s always with the caveat that, if they leave their employer and/or move their savings to a plan with higher fees, they should expect less at retirement.
5. How Do I Find Out More?
If you want to know more about your pension plan, the easiest way to find out is to open your statement and take a look. This sounds obvious but I meet a LOT of people whose statements end up in a drawer or a shredder without ever being opened. If you’re a member of a group retirement plan, you owe it to yourself to open at least one statement per year to see how much has gone in, what you’re invested in, what your rate of return has been over 1, 3 and 5 years and who you have listed as your beneficiary(ies). It’s a 10-minute investment in your financial health that too few people are willing to do and yet it can have a huge impact on your retirement income.
Once you’ve checked your statement, if you have questions about your plan, you should talk to either someone in your HR department, a member of your plan provider’s client care team or your plan advisor (the contact information for these is usually listed on your statement). They will be able to answer your questions and help you make any changes to your contribution amount, investments, beneficiaries etc.