If you’re fortunate to be one of the 1.1 million participants of a defined contribution pension plan, you might be curious how these plans work and what their benefits might be.

A defined contribution pension plan is aptly named, since the employer benefits portion of this plan are related to the contributions. Each year, the employer will contribute a specific dollar amount to the plan. This is usually stated as a percentage of your salary. The employer contribution is often contingent on you making a contribution to the plan yourself, but doesn’t have to be. For example, your employer may match contributions up to 4% of your salary. If you contribute 3%, your employer will contribute 3%, if you contribute 5%, your employer will only give you 4%. This is often referred to as “free money” since for those who would already be saving for their future, their employer is topping that up for them. Sun Life Financial estimates that Canadians are leaving over $3 billion on the table from not contributing to these matching programs. Of course there are many reasons why Canadians are using their money for other things aside from matching, but if it’s a result of lack of knowledge, that’s something that needs to be addressed!

Unfortunately, with this type of plan, the employer is only responsible for providing a contribution to the plan. Once they’ve made the contribution, the rest is up to you. You are given a list of options to invest in based on what the pension plan provider (e.g. Sun Life, Manulife, Great West Life) is offering. It is your responsibility to select the best investment option that you’re comfortable with from a risk perspective that will also provide you with an appropriate return in order to meet your retirement needs down the road. The amount of money you receive at retirement will depend on how much you’ve contributed to the plan, and how well your investments have done.

A Defined Contribution plan is similar to an RRSP (with employer contributions), however your investment options are limited, and there are additional government restrictions around withdrawing your money.

If you saw my previous post on Defined Benefit pension plans, you might be thinking, “this plan isn’t nearly as good as a defined benefit plan. All the risk is on me!” And in general, you’re right. A Defined Contribution plan may provide some advantages over a defined benefit plan though:

First, the money saved in your plan won’t change (aside from savings, withdrawals, and investment returns) if your employer goes bankrupt.
Second, you should have greater flexibility around withdrawing your income in retirement.
Third, you can receive a higher retirement income if you invest in a riskier manner and it works out for you. However, the opposite could be true, especially if you live a long time or your investments fall at the wrong time.
Fourth, a lump sum is available to your heirs if you (and your spouse) pass away before spending the income.

Most individuals don’t have a choice whether they have a defined contribution or defined benefit plan, though it’s important to know which type of pension you have so that you can plan for your retirement accordingly. In addition, depending on the plan you currently have and the plan at a potential employer, this may be a consideration if looking to switch jobs.