How defined benefit pension plans work

Many employers offer a pensionPension A steady income you get after you retire. Some pensions pay you a fixed amount for life. Others save up money for you while you are working. You use that money to create income after you retire.+ read full definition plan as part of your compensation, along with salary and other benefits. There are many types of pension plans. A defined benefitBenefit Money, goods, or services that you get from your workplace or from a government program such as the Canada Pension Plan.+ read full definition pension plan guarantees you a certain amount of monthly retirement income.

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What is a defined benefit pension plan?

A defined benefit pension (DB) pension plan promises to pay you a certain amount of monthly retirement income for life. The amount of your pension is based on a formula. The formula usually considers your earningsEarnings For companies, it’s the money they make and share with their shareholders. For investors, it’s the money they make from their investments.+ read full definition and years of service with your employer.

With most employer pension plans, both you and your employer contribute. Defined benefit pension plans put the responsibility on the employer for investing the contributions. This is to ensure there’s enough money to pay the future pensions for all plan members. If there’s a shortfall in the money needed, your employer must pay the difference.

Some defined benefit plans offer inflationInflation A rise in the cost of goods and services over a set period of time. This means a dollar can buy fewer goods over time. In most cases, inflation is measured by the Consumer Price Index.+ read full definition protection to your monthly retirement income.

This is different from a defined contributionContribution Money that you put into a savings or investment plan.+ read full definition (DC) plan. In a defined contribution pension plan, the amount of your contribution is guaranteed, but not the amount of retirement income. Your retirement income amount may vary depending on how the pension funds are invested.

How do you become a member of a defined benefit pension plan?

It’s up to your employer to determine when you can become a member of a defined benefit plan. Many employers only offer the defined benefit pension plan to full-time employees. This could happen either when someone is hired or after a length of time (sometimes up to two years). Other employers leave the decision to join the plan up to you.

If you’re a part-time employee, you may be eligible to join too. Check with your plan administrator. In Ontario, plans must let you join if you have worked for your employer for 24 consecutive months and you have either:

  • worked at least 700 hours a year for the two previous consecutive calendar years, or
  • earned $18,000 or more in each of the two previous calendar years.

Defined benefit plans provide a pension that is funded in part by your employer. Because of this, it’s usually to your advantage to join the plan as soon you can — even if you are required to contribute, too.

How are your defined benefit pension contributions calculated?

Typically, your employer calculates your pension plan contributions each pay period and deducts them directly from your pay. Remember that:

  • Contributions are usually based on a percentage of your pay.
  • You can deduct these contributions on your taxTax A fee the government charges on income, property, and sales. The money goes to finance government programs and other costs.+ read full definition return.
  • Your employer may raise or lower the employee contribution rate depending on the funding requirements and terms of the plan.
  • These funding requirements are determined by actuaries who review the plan periodically, typically every three years.
  • Your employer also contributes to the plan. Your employer must fund at least half of the pension benefits you earn.

Some plans require you to be a plan member for a certain length of time before you are entitled to benefits. This is called vesting. The length of time varies by province. If you leave the plan before you are vested, you will get your own contributions back, with interest. In Ontario, vesting is immediate. This means you are always entitled to benefits related to your employer’s contributions.

How are your defined benefit pension plan earnings calculated?

Pension calculations are unique to each defined benefit (DB) plan. There are 3 main formula types, but there can be many variations to them:

  1. Final average earnings
  2. Career average earning
  3. Flat benefit

 

  1. Final average earnings

This formula is based on your average earnings in the years leading up to retirement. For example, in the five years before retirement.

Consider the formula below. It’s calculated using 2% multiplied by your average salary in the past five years. And then multiplied by your years as a plan member. If your average salary was $50,000 and you participated in the plan for 30 years your pension would be:

Benefit percentage 2%
Average salary $50,000
Years of plan membership 30
Formula calculation $50,000 x 2% x 30
Annual pension $30,000

 

  1. Career average earnings

This formula is based on your average earnings during the entire period you were a member of the plan.

In this example, the formula is calculated using 2% multiplied by your average salary in your career. And then multiplied by your years as a plan member. If your average salary was $30,000 and you participated in the plan for 30 years your pension would be:

Benefit percentage 2%
Average salary $30,000
Years of plan membership 30
Formula calculation $30,000 x 2% x 30
Annual pension $18,000

Compared to the final average earnings example, your annual pension amount is lower due to the career average salary being lower.

  1. Flat benefit

With this formula, your monthly pension benefit is equal to a fixed dollar amount for each year you are a member of the plan.

Sample formula would be $50 (the benefit amount) multiplied by your years as a plan member (30 years). If you participated in the plan for 30 years your pension would be:

Benefit amount $50
Years of membership 30
Formula calculation $50 x 30
Annual  pension $18,000 annually

 

Some plans increase pension payments to retirees each year to fully or partially match the rate of inflation. This is a highly valuable benefit because it helps your pension’s buying power keep up with rising prices over time.

What if you leave your defined benefit pension plan before you retire?

In Ontario, you have three optionsOptions An investment that gives you the right to buy or sell it at a set price by a set date. The buy right is termed a “call” option, and the sell right is termed a “put” option. You buy options on a stock exchange.+ read full definition when you leave your defined benefit pension plan before retirement. The options include:

  1. Keeping your pension in your plan – you can leave your pension in the defined benefit plan and start collecting it when you reach retirement age. This is known as a “deferred pension.”
  2. Transferring to another pension plan – you could transfer your pension to your new employer’s plan if they will accept it.
  3. Transferring to a locked-inLocked-in An account that you cannot take money out of until you retire. In most cases, you can’t get a cash payout. Your plan may make exceptions if you have a terminal illness, or a small pension benefit.+ read full definition retirement savings accountSavings account A bank account intended for depositing funds. Pays interest and lets you withdraw cash at any time.+ read full definition (LIRA) – you could transfer the cash value of your pension to a LIRA. This option is usually only available if you are under age 55 at the time of transfer.

Caution

If you transfer the cash value out of your defined benefit plan, you give up your pension guarantee.

There are specific circumstances that can happen in your life that may impact your pension. For example, if you become disabled before retirement. Check with your plan administrator about the disability benefit rules that apply to your plan. If you are off work due to disability, you may be able to continue earning benefits under the plan.

If you die before you retire, your spouse (or your beneficiaryBeneficiary The person(s), institution, trustee or estate you choose to give money, property or other benefits when you die. You may name beneficiaries in your will, insurance policy, retirement plan, annuity, trust or other contracts.+ read full definition or estateEstate The total sum of money and property you leave behind when you die.+ read full definition) will likely be entitled to the cash value of the pension benefits you earned. If the benefits are going to your spouse, they may be able to receive them as a deferred pension. Or they may transfer the pension amount to their own RRSPRRSP See Registered Retirement Savings Plan.+ read full definition or LIRA tax-freeTax-free Money that you do not pay tax on.+ read full definition. Otherwise, pension payments are made in cash and are taxable.

Designate a beneficiary for your plan. Benefits can be paid directly from the plan to your beneficiary upon your death. Your plan administrator can tell you how.

What are multi-employer defined benefit pension plans?

Some defined benefit plans are sponsored by many employers. These are called multi-employer plans. They allow employees, who switch employers within the same industry, to maintain their pension coverage.

For example, people working in construction may frequently move from project to project and employer to employer. They could be covered by a single multi-employer pension plan that covers all trades. A portion of their hourly wageHourly wage The fixed amount you earn per hour.+ read full definition would be automatically contributed to the plan.

Plans can vary. Some multi-employer plans have straightforward plan formulas and operate much like single employer defined benefit plans. Others are complex, with elements of both defined benefit and defined contribution plans. These are often called target benefit plans.

Target benefit plans guarantee a pension but provide a “target” amount for the benefit. The actual benefit received could be higher or lower than the target, depending on the investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition performance of the pension plan.

How is your defined benefit pension plan protected?

All contributions made to a defined benefit plan (both yours and your employer’s) are held in trustTrust An account set up to hold assets for a beneficiary. A trustee manages the assets until the beneficiary reaches legal age.+ read full definition for all plan members. When you contribute to a defined benefit plan, this helps keep your contributions safe.

If your employer goes bankrupt, they can’t continue making contributions. The pension plan may not have enough money to pay for the promised benefits. This is called an “underfunded” plan.

Underfunding is often related to the investment performance of plan contributions. For example, a fully funded plan can quickly become underfunded when its investments decline sharply in value. This could occur during an economic crisis or recession.

Because of the high cost that’s involved, employers are allowed to take several years to restore their plans to full funding. If they go bankrupt before this is completed, the plan will remain underfunded. Plan members and retirees may receive less than 100% of their promised pension.

Pension protection fund

Ontario is the only jurisdiction in Canada with a pension protection fund that can help when an employer goes bankrupt. The fund guarantees specified benefits up to $1,000 per month for members who meet certain age and service criteria (with some exclusions). Learn more about this fund and your pension rights

Summary

Your employer may offer you a defined benefit pension plan. This means you will receive a guaranteed amount retirement income from that plan. How much you receive depends on different factors including your annual salary and how long you worked for the employer. Things to be aware of with defined benefit pension plans include:

  • A defined benefit pension plan guarantees you retirement income for life.
  • Some defined benefit plans have inflation protection for retirement income.
  • Ask about plan eligibility rules if you work part time — and join if you can.
  • Contributions are deducted from your pay. Your contributions are tax-deductible to you.
  • Check your plan materials to understand how your pension is calculated.
  • Multi-employer plans let you keep your pension under a single plan if you switch between different participating employers.
  • If you die before you retire, your spouse or beneficiary may be entitled to the cash value of your plan.

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