Although pension plans have changed and evolve over the years, they still remain the foundation of retirement benefits.
There are two main types of pension plans
- A Defined Benefit Pension Plan is a pension where the future benefit is known based on a specific formula that incorporates years of service, salary and a pension factor. What is unknown with a defined benefit plan is the contributions required to provide the benefit. Employees may or may not contribute to the plan but in most cases, the contributions into the plan are usually shared by both the employee and the employer and can change depending whether the plan is properly funded to pay the required future benefit. There are fewer and fewer defined benefit pension plans because they are more costly to administer (actuarial valuations are required every three years to determine if the plan is properly funded) and the liability of the plan is shared by both the employee and the employer.
- 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.
Rules and regulations
The rules for pension plans are guided by pension legislation where the RRSPs are guided under the income tax act. Pension laws can be complicated and confusing because every province has it’s own set of pension rules.
Investment options vary from financial institution to financial institution. Generally with a defined benefit plan, the employee has little to no say on how the funds get managed. Typically an investment manager is hired to manage the funds in the best interest of the group.
For Defined Contribution plans, both the employer and the employee usually have a say in how the money gets invested. Typically there is a range of investment options to choose from.
One of the benefits of pensions contributions is the employer contributions go directly from the company to the pension plan, thus avoiding payroll taxes such as WCB, CPP, EI and vacation pay. In addition, the employee is not required to pay CPP and EI on the employer contributions.
Another benefit of pensions is the ability to institute vesting rules which means that employer contributions are not owned by the employee for a period of time, typically 2 to 5 years.
Under pension laws, withdrawing funds from a pension is very restrictive. One of the main objectives of the pension laws is to ensure lifetime income. As a result, employees cannot make lump sum withdrawals out of a pension like they can with a Group RRSP. Once the money goes into a pension, generally the funds are ‘locked-in’ till retirement.
When the employee terminates, they will have to move the pension funds into a special Locked-in RRSP (LIRA). The age at which the funds can be accessed can vary from province to province but generally is age 55.
Once the employee reached the age of 55, they can take income from the plan by using a Life Annuity, Life Income Fund (LIF) or Life Retirement Income Fund (LRIF).
A pension plan carries more prestige than any other form of employee retirement plan. It is commonly felt that a pension plan is a strong statement from an employer that they are concerned about the long-term well-being of their employee.