Savings rates are the key to the success of Defined Benefit Pensions

Since the introduction of the new Pooled Retirement Pension Plan (PRPP), there have been a lot of critics saying it’s not really a pension and it’s more like a Group RRSP.  Most of these statements are being made because they are comparing PRPPs and Group RRSPs to Defined Benefit Pension Plans.

What makes a defined benefit pension so attractive?

The biggest appeal of defined benefit pensions it that the retirement income is predictable and to a certain extent guaranteed for life.  I get hired to do my financial education programs for a lot of government employees with a defined benefit pension and I see a lot of value from these plans especially for long tenured employees.  It’s really tough to beat a benefit that pays you income in retirement that is consistent, guaranteed, and increasing over a lifetime.  It’s no wonder why so many organizations would like to see a comeback of the defined benefit pension.

Why are defined benefit pensions a dying breed?

The simple answer is they are expensive.  When I use the term expensive, what I really mean is they require significant funding to guarantee that income in retirement.  In other words, it’s not easy to fund a benefit that is consistent, guaranteed, and increasing over a lifetime.  To give you a sense of how much money has to go into the plan to fund these pensions, I will share with you one example.

My wife is a member of the Local Authorities Pension Plan (LAPP).  LAPP is 50 years old and the largest pension plan in Alberta.  They represent more than 206,000 members, employed by 421 different organizations and  represented by more than 50 unions and associations.

Like most pensions, contributions are increasing in 2012.  How much money do members have to put in to fund their pension?

For the first $50,100 of income,
–       Employee pays 8.91%
–       Employer puts in 9.91%
 
After $50,100 of income,
–       Employee contributes 12.74%
–       Employer contributes 13.74%

In my experience, people who retirement with defined benefit pensions have a clear advantage over people who do not have defined benefit pensions.  The real winners are those couples that have dual defined benefit pensions in retirement.

So what makes the defined benefit pension so valuable?

Defined benefit pensions are successful because of two key characteristics:

  1. Mandatory participation.  If you think about it, most people who have defined benefit pension plans would never have saved that money if it was not mandatory to do so.  Most people do not have the self discipline to save regularly over a lifetime.
  2. Increasing contributions.  The required contributions to support the income benefits with defined benefit pensions always go up from time to time.  This is especially true when the markets go down and cause these plans to be ‘underfunded’.  Again, most people do not have the psychological strength to invest more money when times are tough.
  3. Employer matching.  One of the best parts of these pensions is that the employer shares in a significant portion of the funding.  In my wife’s case, the employer is putting more money into her pension than she is.

How can the governments learn from this?

If we go back to the PRPP, I have been very vocal on how I think the PRPP should work.  One of the key focuses of the PRPP mandate is to prove a low cost benefit for members.  While I am an advocate for low cost investing, I think they missed the point and can learn from the real advantages of the defined benefit pension.  All they have to do to make the PRPP work better is to:

–       Make participation mandatory

–       Encourage employers to match contributions

–       And ensure that contributions will increase over time.

I’m self-employed without a pension.  Let’s just assume I make the same $50,100 per year and I contribute to the new PRPP program.  Let’s just say I contributed as much to the PRPP as my wife has to contribute to her LAPP defined benefit pension – $9428.82 per year for 25 years.  The difference is I paid the whole thing but my wife only paid half because the employer paid half.

After 25 years of membership in the LAPP pension, my wife would get an annual pension of $17,535 per year.

My 25 years of contributions into the PRPP would grow but the end value would really depend on how I do with my investments

At 3%, I would have $343,768

At 4%, I would have $392,679

At 5%, I would have $450,019

At 6%, I would have $517,317

At 7%, I would have $596,375

Even at the most conservative return of 3%, I could still replicate the $17,535 per year of income and it would last 28 years.

What’s my point?

If you want higher retirement income, you have to save more and stay disciplined.  The best workplace savings programs are the ones that are require participation, have a matching incentive and also increase contributions over time.  I don’t care as much if it’s a defined benefit pension, defined contribution pension, Group RRSP or the new PRPP.  Any plan with these characteristics will help Canadians to retire with more income!

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 JimYih.com and Clearpoint Benefit Solutions.

One Response to Savings rates are the key to the success of Defined Benefit Pensions

  1. Just wanted to say that this is a great post. I work for a telecom company that offers a Defined Benefit Plan. I have been with the company for 14yrs. At year3, my then FA suggested that I stop contributing and move my money to her for investing. She cited numerous negatives of a DBP like reduction in RRSP contribution room by the PA, all DBP are underfunded, what if the company goes bankrupt, etc… She scared me into going with her.
    Now that I have read your post, I realized how stupid I have been these last 11 yrs. I will re-start contributing to my DBP. However, are there ANY negatives to a DBP??

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