What we often think of as a pension is actually a specific subset of a pension called a defined benefit (DB) pension. In addition to DB pensions, there are also other pension plans such as defined contribution pensions (DC) and hybrid or cash balance plans. Read on for more details…
Defined Benefit (DB) Pension
A DB pension is an income stream offered to an individual from an organization, typically at retirement, wherein the individual receives a payment from the organization at regular intervals, typically until death. Payments can be set at a fixed value upon retirement, or adjusted for inflation year over year. Some plans also allow for a surviving spouse to receive either a full or partial pension payment.
The main distinction of a DB pension compared to other alternatives is that the income stream is typically calculated as a function based on age, employment salary, and years of employment at the company. This income stream is then given to the pensioner regardless of the returns of the markets, thus providing assurance of payment amounts. This means that if the pensioner was to receive $50,000 in a given year, and the S&P 500 index has a return of -30%, the pensioner would still receive the $50,000, and the same situation would be expected if the index has a return of +30%.
In order for a typical investor to generate returns to produce an income stream, cash must be invested to produce a combination of capital gains and income (dividends, interest, etc.). These investors are then directly exposed to the risk and return of the particular assets that were purchased. In the case of a DB pension, however, the individual is not exposed to the risk and return of the particular assets that were purchased. The sponsor (the company or government organization paying the pension) will invest cash to purchase assets and hold them itself. In this way, the sponsor takes on the risk and reward of the investments and then passes on the income earned in the form of a pension payment to the pensioner. Pensioners effectively pay into the plan (provide cash for the sponsor to allocate) during their working life, typically through deductions in their paycheque.
In Canada, all employed Canadians 18 years of age or greater are automatically enrolled in the Canada Pension Plan (CPP) [Quebec Pension Plan in Quebec], which is a type of DB plan. In addition to these government DB plans, individuals may also be eligible to receive a pension from their employer. Although a private company DB plan may sound like a great deal, our clients should be aware that there are still risks to consider. Even though the private company has taken on the market risk of the investments (see the example with the S&P 500 above), there are still risks to the pensioner, primarily that the financial health of the private company is sufficient to keep the DB pension plan funded through the retirement of the pensioner. For example, if the business declares bankruptcy, or cuts funding to its pension, the pensioner may not receive scheduled payments. In addition, DB plans are typically not transferable from employer to employer, and are typically not accessible until retirement, although lump sum payment options may be available to access the funds earlier, though typically at a reduced level.
Defined Contribution (DC) Pension
In a DC pension, the employer and employee both make regular contributions to an investment account, with the contributions usually specified as a percentage of annual income. Depending on the configuration of the plan, the employee may have full access to the money and can re-allocate it as seen fit, or it must be kept within a specific set of investments provided for by the employer.
Regardless of the plan configuration, once the contribution is made by the employer, the money is typically invested at the employee's discretion, namely, the employee bears all the risk of the investment. This means that if the pensioner and employer were to contribute $10,000 to the DC pension in a given year, and the S&P 500 index has a return of -30%, the pensioner would lose the entire 30%, or $3,000, and the same situation would be expected if the index has a return of +30%, namely a gain of 30% or $3,000.
Another important point to note is that there is no assurance of pension benefit payments with a DC pension. Once the assets at retirement are determined, market forces will determine the income provided for by the fund assets through capital gains, and investment income (dividends, interest, etc.). The pensioner’s former employer would bear no responsibility for the DC pension being able to fund the retirement of the pensioner or not.
However, the main benefits of the DC pension are that they typically allow for increased flexibility and control of the individual over his/her financial assets, and do not link the health of the individual’s pension to that of their former employer.
Hybrid and Cash Balance Plans
In addition to the DB and DC pensions mentioned above, there are other types of pensions that are less commonly offered, such as hybrid or cash balance plans.
Hybrid plans can include Target Benefit plans, wherein contributions are made per a DC plan, but these contributions are determined by a formula that calculates the amount needed to accumulate sufficient funds at retirement (similar to a DB plan).
Cash Balance plans can be best described as DB plans that are reported to the pensioners as a (hypothetical) DC plan. This may allow for increased portability between employers, should pensioners switch jobs prior to retirement and wish to continue to grow that specific pension account.
Conclusion
Hopefully this helps to provide a concise summary of some of the various pension options available to individuals.
It should also be noted that pension plan contributions will typically reduce the available room in an individual’s RRSP. CJ Capital can help you determine if this is in fact the case, and adjust your RRSP contribution rates to take this into consideration.
Please feel free to contact CJ Capital if you have any further questions or would like to discuss your specific situation.