A defined benefit pension is a type of pension plan sponsored by your employer. Benefits are calculated based on factors such as length of employment, salary history, and age rather than dependent on investment returns.
With flexible payout options and retirement dates, plus a reliable estimate for your retirement income, a defined benefit pension can help Canadians retire with ease!
What is a Defined Benefit Pension (DBP)?
Like I mentioned above, a defined benefit pension is an employer-sponsored pension plan. DBPs combine contributions from both you and your employer in a pension fund. These funds are then invested at your employer’s discretion.This plan is called a defined benefit plan because the formula for calculating benefits is set in advance.
Benefits can be issued as monthly payments or a lump-sum payment. Because your employer is responsible for investing the contributions, if there is a monetary shortfall they are responsible for covering the difference. With a DBP, you get to lean on your employer to make investing decisions which should take some stress of your shoulders!
How much will I get from my defined benefit pension?
The total amount you will get from your pension is dependent on a few things. Pensions reward seniority and loyalty. The higher your income and the longer you stay with your employer, the more you’ll receive from your pension in retirement. Additionally, your age upon retirement will have an effect on your earnings.
The income you receive in retirement is typically calculated using your highest earning years at your employer, multiplied by your years of service.
Here’s what calculating your annual pension would look like with a DBP: up to 2% x your average salary in the past 5 years x the number of years you were a plan member.
Defined Benefit Pension vs Defined Contribution Pension
There are 2 main types of employee pension plans: defined benefit pensions and defined contribution pensions. Both are good options for your retirement, but they do have a couple key differences.
A defined benefit pension provides a guaranteed income in retirement. A defined contribution pension (DCP) does not have a pre-determined income. Instead, it is dependent on factors such as what you pay into the pension and how your investments perform. A DCP allows you to tailor your investments yourself rather than leaving it solely in the hands of your employer.
Both plans are valuable and help people retire with more financial security. While the DCP gives you the freedom of choosing your own investments based on your personal goals. Generally defined benefit pensions pay more in retirement than defined contribution. Though, you have no active involvement in the investing choices. The option that is right for you may depend on your personal financial goals and your employer’s offering.
How does a Defined Benefit Pension affect my savings?
A defined benefit pension will affect your retirement savings in two ways:
- You will not need to save as much for retirement in your own accounts (like the TFSA or RRSP) because you will have pension income in retirement.
- Your RRSP contribution room will be reduced each year because your pension contributions count towards it.
Do I need to save if I have a pension?
In short, yes. You do need to save for retirement even if you have a pension. While having a pension definitely reduces the amount you need to save, it is still important to do so to full prepare you for retirement!
A pension will typically provide you with 40-60% of your working salary in retirement. Most financial advisors suggest you need at least 70% of your working income in retirement. And the Canadian Pension Plan will replace less than 25% of your working salary in retirement if you are over 60 and have contributed to the plan at least once.
While saving on your own does not offer the same benefits, it’s still important to do so alongside your defined benefit pension. This will ensure you’re prepared to support yourself through retirement and ultimately that you are saving as much as you can. RRSPs and TFSAs are both great savings vehicles to accompany your pension earnings.
How do I factor my pension into my CoastFIRE plan?
CoastFIRE is a branch of the FIRE method for early retirement. CoastFIRE involves putting aside enough savings and investments to support a comfortable retirement at your targeted retirement age. You leave these savings on autopilot so you don’t have to aggressively save but rather, coast.
Pensions make it easier to hit your CoastFIRE number sooner. You don’t have to save as much for retirement on your own because your employer is doing it for you!
Factoring your pension into your CoastFIRE plan is simple. Your pension is defined, so you should be able to know exactly how much you will receive in retirement. Your adjusted CoastFIRE number that you have to save is the remaining deficit.
Don’t forget to consider how long you intend to stay at your employer when determining your CoastFIRE goal as well. If you plan to retire early, or you think you may change employers at some point in your career, you will need to save more in your TFSA and RRSP to make up for what your pension will not cover.
Do pension contributions count towards RRSP contributions?
The short answer: yes!
Because you are already paying into a pension plan, the amount you can contribute to your RRSP will be reduced. This is called a pension adjustment. It is calculated by your employer based on a set formula that considers your annual salary and your maximum pensionable earnings for the year.
You will likely still have RRSP contribution room available even if you make pension contributions. This is because pension contributions are usually significantly below RRSP contribution limits.
Usually, a pension will require contributions anywhere from 8% to 13% of your salary. But your RRSP limit is 18% of your gross income, so even if you make pension contributions you will still have RRSP contribution room leftover.
If you’re unfamiliar with RRSPs, here’s the RRSP explained to fill you in on the information you need to navigate your pension while keeping it in mind!
There are vehicles for savings other than the RRSP. If you have a pension, the TFSA is actually a superior retirement savings vehicle for you. It has lower contribution limits than the RRSP, but overall offers a lot of flexibility. You should aim to max out your TFSA before you save and invest in an RRSP.
What happens if I leave my job with a pension before I retire?
If you’re thinking of leaving your job before your retirement, don’t worry. Your pension is still yours.
You typically have 3 options of what to do with your pension if you leave your employer:
- Leave your pension with your previous employer.
- Transfer your pension to another employer.
- Receive your pension as a taxable cash payout.
Typically, you will receive your pension contributions back, either as a cash payout or transferrable to a registered account like a LIRA or RRSP. You may or may not receive your employer contributions, depending on the terms of your pension.
Here’s a brief breakdown on the different options available to you if you leave your job before you retire:
Leave your pension with your employer
The first option is to stay invested in your employer plan and receive a small income in retirement. You pension income in retirement will be proportional to how much you paid into the pension, so if you are leaving your job after only a few years it will be very small.
If you feel you may have more success investing your money elsewhere in retirement, it’s worth considering transferring your pension to your new employer or your own self-directed investing accounts for a more lucrative payoff.
Transfer your pension to your new employer
If your new employer also has a pension plan, you may be able to transfer your money over. Check with your pension provider to see if this is possible for you. Normally, employers offer you some time past your leaving date to decide on what to do with your pension.
Get paid out a lump sum for your pension contributions
The third option is to get paid out a lump sum amount if you leave your employer with a pension. Typically you can receive all or part of your pension contributions paid out as taxable income, or simply transfer to another tax-sheltered investment like a LIRA.
A LIRA or, Locked-In Retirement Account, is an account you open to transfer an employer pension to after you leave a job. A LIRA restricts you from making any contributions or withdrawals until retirement. But it does grant you the freedom of managing your financial assets in a way you couldn’t if you left your pension with your employer. Often your pension contributions can be moved to a LIRA, but your employer’s match will be paid out to you as taxable income.
You can and should invest your retirement savings in the stock market! Most financial institutions offer LIRAs. Or you can open one with a brokerage like Questrade which is a great, affordable option. If your pension payout is small, you can transfer it out of a LIRA then move it into an RRSP. It’ll have a bit more flexibility for growth in an RRSP.
Cash payouts are an option, though, it isn’t typically the option in your best financial interest. Only take a cash payout if you are in dire need of money for a financial emergency. Otherwise leave your retirement savings for retirement!
A defined benefit pension is a great option to take advantage of if it’s offered by your employer. It’ll ultimately provided you with a better financial cushion in retirement than you might get from solely saving on your own. But, it’s important to keep up your saving regardless of your pension, retired you will thank you!
Not all Defined Benefit Plans work this way, especially in regards to investment risk. In my job, the pension amount is not set at 2% of pay or anything like that, but by an amount the pension fund determines is necessary to maintain and grow the fund. The fund’s return is applied to that sum first, and then the remaining sum is divided 51/49, with the employees paying 51% and the employer paying 49%. So for example, if the fund is worth $20 billion, it needs an estimated $2 billion to maintain or grow once payouts are calculated. The fund returned 8% last year, so the $2 billion will be funded from the $1.6 billion in growth and the remaining is to be made up of the pension contributions, $204 million from members and $196 million from employers (the difference between the members and the employers is to cover the COLA). Therefore, amongst the 32000 employees, an average of $6300 per employee needs to be contributed. The employer does not take on all the risk, it is shared risk. If the fund goes down, contributions must rise. Currently, our contributions are also paying off an employer shortfall that was part of bargaining.
You’re conflating 2 different things. You are correct in how the contributions are determined but the 2% is referencing what you will receive (the $2B in your example). I believe you’re talking about the calculation to determine what is taken off your cheque while working (your contribution) while the 2% is part of the calculation to determine what you will be paid from the pension in retirement
Thank you so much for this article. I have a DB plan and always wondered how much I should save outside of it.