What is a pension plan and how does it work?

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 can provide you with income during retirement. Being part of a pension plan may help give you more peace of mind about the future during your earning years.

On this page we answer:

What is a pension plan?

A pension plan is designed to provide you with retirement income. Many employers offer pension plans as part of their employee compensation. The employer and employee make regular contributions to the plan. You can only receive income (or make withdrawals) from these plans during retirement, typically from age 55 onward.

Pension plans can offer:

  • higher rates of employer contributions than savings plans (for many plans, but not all).
  • built-in discipline to ensure you have the income you need in retirement.

There are two main types of pension plans:

  1. 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 (DB)
  2. Defined contributionContribution Money that you put into a savings or investment plan.+ read full definition (DC)

How do defined benefit (DB) pension plans work?

A defined benefit pension plan promises to pay you a certain amount of retirement income for life. The amount income you receive is based on a formula. That 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.

In most plans, both you and your employer contribute. Your employer is responsible for investing the contributions 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.

How is a defined benefit pension plan calculated?

A formula is used to calculate your defined benefit. For example, a company could calculate the defined benefit based on:

  • 2% of your average salary per year of employment.
  • multiplied by the number of years you were a plan member.

If you were employed for 30 years, with an average annual salary of $50,000, the annual pension would be: $30,000.

 

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

Learn more about defined benefit pensions.

How do defined contribution (DC) plans work?

In a defined contribution pension plan, the amount of your contribution is guaranteed, but not the amount of retirement income.

Usually, both you and your employer contribute to the plan. Your employer may match your contributions. You are responsible for investing all contributions to grow your savings. In this way, the plan is similar to an RRSP.

The amount of money available for your retirement depends on:

  • the total contributions made to your accountAccount An agreement you make with a financial institution to handle your money. You can set up an account for depositing and withdrawing, earning interest, borrowing, investing, etc.+ read full definition.
  • the investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition returns this money earned.

At retirement, you use the money in your account to generate retirement income. You can do this by:

  • buying an annuity from an insurance companyInsurance company A company that sells insurance products. Some companies sell only life insurance. Some sell only property insurance. Others sell all types of insurance.+ read full definition, or
  • transferring your savings to a locked-in retirement income fund (LRIF) or similar income fund designed specifically for pension savings.

Learn more about defined contribution pensions.

What is a workplace savings plan?

Some employers offer savings plans instead of, or in addition to, pension plans. These types of plans are more flexible. You may not be allowed to take money out while you are with your employer. But once you leave your employer, you can transfer your savings out of the plan to use for retirement or any other goal.

Savings plans can offer:

  • the flexibility for you to save for goals other than retirement.
  • investment management fees that are often lower than those you pay as a retail investor.
  • more savings – if both you and your employer contribute, your savings power is doubled.
  • automatic saving – your contributions come off your paycheque before you may be tempted to spend it on other things.

Workplace savings plans can vary greatly in their design and purpose. It’s important to understand how your employer’s plans work and any rules that apply. Make sure you know about fees that apply, and whether you can opt-out of the plan later.

 

Remember

Employers may offer other financial resources besides pension or savings plans, such as learning tools, access to a professional financial advisor, and online account access. Check what resources may be available at your workplace.

Summary

Your employer may offer a pension plan or savings plan as part of your compensation. These are both ways to help you save for the long termTerm The period of time that a contract covers. Also, the period of time that an investment pays a set rate of interest.+ read full definition. Keep in mind:

  • Pension plans have a single focus: retirement.
  • Savings plans can be for any goal. But you may not be able to withdraw money from your savings plan while you are with your employer.
  • Defined benefit plans guarantee you a retirement income for life, based on a formula.
  • Defined contribution plans guarantee contributions, but not your income, in retirement.

 

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