16: Defined Contribution Pension Plans
If your employer offers you a pension, that’s great. Full stop. You deserve that and so much more for trading your time for their profit. Understanding what that pension means, how it works when you’re employed, and what happens to it if you leave your employer or retire is important.
After all…it’s your money. You took it out of your wages, and with your labour you created your employer’s ability to contribute to it.
We’ve talked about defined benefit pensions before, in episode 7, and we’ve talked about investing. Today we’re going to talk about defined contribution pensions, which are a hybrid of the two. The difference between them is what you’re entitled to and what you know in advance.
Defined Benefit vs. Defined Contribution Plans
In a defined benefit plan, you’re entitled to the amount you receive when you retire or leave the plan, whether it’s the commuted value or a lifetime monthly amount. You know the amount ahead of time, and the formula for how it’s calculated.
In a defined contribution pension plan, you know how much you and your employer contribute, but not how much you’ll be able to get from it when you’re retired. You’re entitled to the amount of money that builds up in the plan thanks to those contributions.
Inside a Defined Contribution Plan
Your employer has chosen a service provider, often a life insurance company like Canada Life or Sun Life, who usually manages all the required reporting and administration to you and your fellow pension plan members and to the provincial regulator.
Your employer has also selected the minimum amount of your and their contributions, usually a percentage of your pay. Sometimes, you can contribute more than the minimum, and sometimes your employer will match those extra contributions, up to a maximum amount.
They’ve also chosen what investments are available to you inside the plan. They’re almost always some version of a mutual fund that owns stocks, bonds, and other kinds of investments inside of it. Sometimes the list of funds you can choose from is very short and sometimes it’s so long your head spins.
Each of those funds charges you a fee that covers the costs of running the fund (including picking the stocks and bonds, bookkeeping and accounting, regulatory filings, management salaries, and a profit margin). Too often the fee for each fund is buried somewhere else in the paperwork.
You’ll get statements at least every year, and some of them will include an estimate of the income you will get from the plan when you retire.
This is not a guarantee!
The amount is a projection, based on how much your plan might be worth at retirement and assuming you buy an annuity with that future balance, calculated by our actuary friends.
A Defined Contribution Pension Plan is Like an RRSP…Sort of
Your contributions to a defined contribution plan are tax-deductible, like your RRSP contributions. There’s a maximum amount that can be contributed each year, also like your RRSP contributions.
But!
RRSP contributions are made during the year, you get a slip that tells you how much, in total, you contributed at the end of the year, and you deduct that amount from your income when you file your tax return.
Defined Contribution Pension Plan contributions are deducted from each paycheque, and usually before your employer calculates how much income tax to withhold, which means they’re already deducted from your income. You don’t get a contribution slip at the end of the year, and you don’t deduct the amount you contributed when you file your tax return.
Instead, the amount of your employer’s contributions are deducted from next year’s RRSP contribution room by way of a Pension Adjustment, reducing the amount you can contribute to your own RRSP in the following year.
Leaving Your Employer or Retiring with a Defined Contribution Pension Plan
The money in your plan is yours, and you can take it with you when you go. If you’re retiring, the service provider will send you a fat stack of paperwork that tells you what your options are, and they’re usually some combination of:
Setting up regular withdrawals (these will be taxed like withdrawals from a Registered Retirement Income Fund are)
Buying an annuity, which is an insurance product that will pay you a fixed amount of money every month in exchange some or all of the money in your account
Transferring the entire account to another institution as a Locked In Retirement Account
If you’re leaving, but not retiring, you can transfer the money that’s in your Defined Contribution Pension Plan tax free to a personally owned Locked In Retirement Account, and keep it with the original service provider or move it to any other institution you’d like.
Each province has its own rules for getting the money out of a Locked In Retirement Account, but usually you need to be over a certain age, like 55, experiencing financial hardship, be unlikely to live much longer, or have a small enough balance in the account that it doesn’t need to stay locked in.
In the end, a Defined Contribution Pension Plan is a mash up between a Defined Benefit Pension Plan and an investment account. Very little about it is guaranteed, so knowing how it works (and how it doesn’t), is the best way to get the most out of it.
Resources
05: Knowing What You're Invested In