Pension Plans are the Foundation of Retirement Planning

Although there are many types of pension plans, there is at least three main elements in a pension plan arrangement: the plan sponsor or the employer, the plan itself, and the funding medium or the “Fund”.

Different types of pension plans

Pension plans can vary greatly in terms of their structure and the benefits they provide. The two most common types of pension plans are the defined benefit plan and the defined contribution (or money purchase) plan. Some employers offer a combination of the two types of plans – known as “hybrid” or “combination” plans.

The first thing we need to do is distinguish between the two basic types of pension plans:

1. Defined Benefit Plan

Under the defined benefit plan, the known element is your pension benefit at retirement. This benefit is usually expressed by three variables:

Number of years you worked for the company

Your salary (it is usually an average of a number of years)

A predetermined factor like 1% to 2%

The employee contribution is often a fixed percentage of salary, up to a maximum. Contributions required from the employer are usually determined by actuarial calculations and may be subject to fluctuation caused by market and experience risk. If, however, the plan is terminated, the employer is responsible only for those funding payments, which are due at the time of termination and are not required to fund any shortfalls on wind-up.

2. Defined Contribution Plan

Under the defined contribution plan, the future benefit is the unknown. The future benefit depends on how much money is put into the plan by the employer, the employee and the rate of return earned by the investments. What is ‘defined’ in this plan is the amount of contributions that will be put into the plan. This is usually expressed as a percentage of income. Employees bear the market risk and, provided that contributions are remitted in a timely fashion, defined contribution plans are, by definition, always fully funded.

How does this apply to you?

The second is there is a trend to replace defined benefit plans with defined contribution plans. It is pretty clear that individuals need to take control of their retirement planning. Fewer employers want to bear the risk of defined benefit plans making RRSPs more important to most Canadians.

If you are part of a pension plan, your pension will likely be the cornerstone of your retirement income planning. It is imperative that you know what kind of Retirement Pension Plan you belong to and how much income your pension is likely to give you in retirement.