Back in March 2012, I wrote a post titled Building My Portfolio for Retirement, with Dividends and Bonds. In that post I discussed that I was one of the fortunate ones to have a defined benefit pension plan through my employer. My pension is an additional source of monthly income, along with my investments, to help me in retirement.
I think it is critically important to understand the foundation of your retirement, the pensions you are entitled to receive, and how much monthly income you can expect your investments to spin-off. I pointed this out in my most popular article – Can You Live Off Your Dividends? When you put it all together, pensions are an important component of that monthly income.
Here is how the basic pension plans work in Canada, both government and employer sponsored:
1. Canada Pension Plan (CPP)
All Canadians who have contributed to the Canada Pension Plan (CPP) during their working years can apply. This is a government benefit. Canadians can apply as early as age 60. The full monthly benefit is available at age 65, with a 0.5 per cent reduction in the pension payout for each month before age 65 that someone begins receiving it. The total reduction is approximately 30% if you collect CPP at age 60, so in effect the government is penalizing you for taking early retirement.
The Canada Pension Plan is a contributory plan. This means your benefit is based on how much you contributed to the plan while working. The maximum CPP benefit rate is currently $986 per month.
2. Old Age Security (OAS)
The Old Age Security (OAS) Pension is a monthly benefit available to most Canadians 65 years of age or older who have lived in Canada for at least 10 years. This is a government benefit. Eligibility for OAS is based on residency and has nothing to do with employment history. The current maximum OAS monthly payment is $544.
From an investor’s point of view OAS can present a problem because OAS is based on income. RRSP withdrawals are counted as taxable income. Therefore, RRSP withdrawals can result in claw-backs to your OAS pension amount and/or entitlement, if your retirement income is over 69K. For most Canadians that will likely not be an issue, but for those living off their investment income it may well be. Canadian finance guru Jim Yih provides an excellent article on Minimizing OAS Clawbacks.
3. Defined Benefit Plan (DBP)
In Canada, government and public service workers, as well as some private sector employees, are able to sign up for a defined benefit pension plan. This is the granddaddy of all the pension plans, and usually involves mandatory enrolment as a public service employee. But enrolment is well worth it!
For every dollar you contribute to your defined benefit plan, your employer also makes a contribution, and in my case my employer matches it. The key point with a Defined Benefit Pension Plan, is that the amount of your monthly pension payment in retirement is fixed and guaranteed, and in most cases for life. Payment is primarily based on years of pensionable service, and your age at retirement. The Defined Benefit Plan is worth gold, because your monthly payment is fixed and guaranteed at retirement.
4. Defined Contribution Plan (DCP)
For those in the private sector, the alternative is a defined contribution plan, assuming your employer offers one. Rather than a guaranteed benefit amount at retirement, your employer simply makes a contribution as you contribute to the plan. In most cases the employer will match your contribution. Most Defined Contribution Plans rely on managed investments such as mutual funds through life insurance companies.
However, you are not guaranteed any defined benefit. All you are guaranteed is that your employer will contribute to the plan. This usually means you are relying on the value of your portfolio when you retire, how well the investments in your plan performed over the years, and the market value of your investments at retirement. However, when you consider for every dollar you contribute, your employer usually contributes another dollar, that is still a pretty good deal.
Why Employers Prefer Contribution Plans
The Defined Benefit Pension Plan is becoming an expensive overhead that many employers are not willing to bear. Many employers are scrapping the coveted Defined Benefit Pension Plan, and opting for the less costly Defined Contribution Plan. A major reason is that defined contribution plans are not linked to a specific benefit formula based on age and years of service. Employees simply receive the amount that they have been able to save with employer including matching contributions. In addition, defined contribution plan funding requirements are lower than the funding required for defined benefit plans. Simply put, there is less obligation and less cost for the employer with a contribution plan.
The Defined Pension is Worth Gold (if you have one)
The Defined Benefit Pension Plan (DBP) is considered the Gold Plated Pension for working Canadians. But less and less employees will be able to collect Defined Benefit Pension plans. More private sector employers will be converting and/or offering their employees Defined Contribution Plans. The Defined Benefit Pension Plan in Canada may indeed become a scarce commodity for retired workers. The DBP is worth gold if you have one.
Reader’s do you have a defined benefit or defined contribution plan through your employer? What do you think of your defined benefit or contribution plan?