A defined benefit pension plan is a retirement savings plan offered through your employer. The big draw to defined benefit pension plans are just that. In retirement, you have a defined amount that you will receive each and every year. This amount is often linked to inflation. As items become more expensive each year, your pension income goes up by the rate of inflation. Another benefit of this type of pension plan is that it provides you income for as long as you live. If you live to age 150, you’ll still receive the same amount of money! Survivor benefits are also often available. If you pass away, your surviving spouse will continue to receive a portion of the pension. Many plans have this survivor pension set at 60% or 66%, while others will allow you to choose the amount of survivor benefit you want. If you choose a 100% survivor option, the ongoing pension you receive will be slightly lower, but your survivor won’t see a drop in their income when you pass away.
How is the benefit calculated? This is different for each plan but it is a calculation based on the number of years of service within the plan, and your employment income. The employment income used is often an average of your final 5 years’ income, or sometimes your best 5 years.
You may or may not contribute to the plan yourself, but your employer certainly does. An actuary uses estimates and assumptions to calculate how much you and your employer need to save each year in order to provide that benefit. This is typically less than you would have to save yourself for the same amount of pension income because it pools the risks across many retirees with different ages who will pass away at different times.
Ultimately, your employer take on all of the risks. If there isn’t enough money in the pension plan to provide the benefits that have been promised to you, your employer will have to make up the difference.
These plans also allow for early retirement if you meet certain thresholds, like the 85 factor. If your years of service (i.e. the number of years you’ve been enrolled in the pension plan) and your current age add up to 85, you can retire early with an unreduced pension. For example, let’s say that you are 55 years old, and you started working and paying into the pension plan when you were 25, so you have 30 years of service. Adding your age, 55, and your years of service, 30, would result in a total of 85. This means you’d be able to retire at age 55, with an unreduced pension. If you don’t meet this 85 factor and want to retire at age 55 still, you can, but you won’t get the full pension promised to you.
You get a guaranteed amount of money from retirement for the rest of your life, you don’t have to take any investment risks, and often your monthly pension increases with inflation and continues to provide your spouse with income even after you die. What’s the catch? With anything there are tradeoffs. One major drawback is that you don’t have control over your money, although some view this as a good thing: there are professionals looking after your money. Secondly, if you don’t live a long life, your heirs may not get as much in your estate as they would have if you had savings outside of the pension plan. And finally, if your employer goes bankrupt, the benefit you receive could be significantly lower than what was promised.
Usually, the benefits outweigh the risks when it comes to defined benefit pensions. Unfortunately, they’re declining as employers no longer want to take on the risk and expense associated with these types of plans. The number of Canadians with private Defined Benefit plans declined by 20% from 1977 to 2012. So what’s replacing these plans? Defined Contribution plans, which I outline in my next post.
