How Does My Pension Fit Into My Retirement Plan?
If you have worked in Canada, you will have contributed to the Canada (or Quebec) Pension Plan (CPP/QPP) and will be eligible to receive regular monthly payments from the plan as early as age 60. If you have been a resident of Canada for at least 10 or 20 years (depending on whether you retire inside or outside of Canada) you will be eligible to receive another kind of government pension known as Old Age Security (OAS) from as early as age 65. If your income after age 65 is below a certain threshold, you may also receive the Guaranteed Income Supplement (GIS). However, for the average middle-income Canadian, these government programs were never intended to fund your entire retirement income needs.
The Three Pillars of Canada’s Retirement Income System
Pillar 1. Canada Pension Plan/Quebec Pension Plan
CPP/QPP provides monthly payments to people who contributed to it during their working years. Until a few years ago, the program was designed to replace approximately 25% of your income from employment. However, starting in 2019, CPP contributions have been gradually increasing, intending to eventually replace one-third (33.33%) of income. This increase is referred to as an enhancement.
Pillar 2. Old Age Security
The second pillar is OAS. This retirement benefit comes from the general revenues of the government, not employer-employee contributions. However, it should be noted that, if your income while in receipt of OAS exceeds a certain threshold, your OAS payments will be subject to a pension recovery tax.
Pillar 3. Employer-Sponsored Pension Plans and Personal Savings/Investments
The first part of the third pillar, Employer-Sponsored Pension Plans, is the main topic of today’s blog post.
Employer-sponsored pension plans include the following:
Defined Benefit (DB) Plan
This is the plan that most people think of when they hear the word pension. As part of the employment agreement, the employer agrees to provide an annuity (a steady stream of known payments) upon reaching a certain age or meeting a qualifying factor (e.g., a combination of age and years of employment). The amount of the pension is calculated on a combination of years of service multiplied by a percentage or flat amount multiplied by salary (based on one of career average earnings, the average of the employee’s final years, or the best earnings).
This kind of pension is becoming increasingly rare. Public service pensions at all levels of government are probably where they are most common, followed by many union jobs. Some of the largest companies in Canada also offer defined benefit plans. Inflation protection may or may not be part of the package. Some pension plans are contributory, i.e., both the employee and employer contribute to the plan, while others are fully funded by the employer alone.
Is this the best kind of pension? I think most would say so. You don’t have to worry about whether you have saved enough money or how well your investments have done over the years. The responsibility to provide the agreed-upon amount rests with the employer, not the employee.
However, since the responsibility for the pension plan rests with the employer, it is important to know whether your employer is taking care to fund the plan. Pension managers invest the contributions made to the plan, but if the plan does not generate sufficient returns, then the employer has to cover the shortfall. If the employer is having some financial difficulty, it might put the viability of the plan in jeopardy. For that reason alone, retirees sometimes choose to commute their pension and put the proceeds into a Locked-In Retirement Account (LIRA) and eventually into a Life Income Fund (LIF) or use it to buy an annuity from an insurance company. Situations when commuting a DB plan would have been a better choice include companies like Nortel, and more recently, Sears.
Defined Contribution (DC) Plan
The responsibility to maintain a defined benefit pension plan has persuaded most companies to shift away from that option. Instead, many employers now offer a defined contribution or DC plan. Although it is also a kind of Registered Pension Plan, it is much simpler than the DB Plan. It is similar to an RRSP in some respects.
Consider the name. In a DB plan, the benefit, that is, how much you are going to be paid in retirement, is defined. In a DC plan, the defined element is not what you receive in retirement, but what you contribute while employed. For example, you might contribute 5% of your salary, which will often be matched by your employer on a 1-to-1 basis, or some other ratio.
For the employer, this is a great arrangement. The employer has to contribute money but no longer has to be concerned about there being enough money. That onus is put on the employee, who is given the responsibility to choose from a range of investments.
Once the employee retires, the assets in the plan can be used to purchase a life annuity or LIF. If you do not want or need to draw on your accumulated pension assets, you may be able to retain the assets in the pension plan as a terminated member or transfer them to a LIRA.
DB, or Not DB, That is the Question
Actually, it’s not usually a question. It all depends on what your employer is offering. However, you could ask yourself which type of pension is better. The DB pension has for years been thought of as the gold standard. At retirement, you continue to receive a steady income stream and don’t have to worry about it at all. Furthermore, once you die, your surviving spouse will, depending on the terms agreed to, likely receive somewhere between 60 to 70% of what you would have been receiving. However, once the survivor dies, the value of the pension is usually lost, unless there is some kind of guarantee option applied. This usually works well if you live a long time, but if both you and your spouse die shortly after retirement, this may feel a bit disappointing, especially to any surviving beneficiaries.
The DC plan, in contrast, does not guarantee a return, but you know exactly the balance in your account. If you elect to open a LIF, then you can choose your investments and take out as much or as little as you wish, within mandated minimums and maximums. If you die early, the entire amount can be rolled over to the surviving spouse without any reduction in the amount received, except as the market performance of your investments dictate. Furthermore, unlike in the case of the DB plan, when the surviving spouse dies, the entirety of the remaining balance can be designated for your surviving children. However, unlike the case with your surviving spouse, it does not roll over to your children tax-free. Instead, tax is owed at regular rates, as though you had withdrawn the full amount of the LIF at once. If the balance is high, and it can be in the 100s of thousands of dollars, a substantial tax bill is waiting.
I mentioned market performance in the previous paragraph. In the long run, it may be that the retiree with the DC plan can do better in terms of investment returns, but market performance can be volatile, as the year 2022 has shown. Nor are returns guaranteed. In other words, by transferring your pension assets into a LIF, you are introducing market risk that is not there in the case of the DB pension. Of course, with a DC plan you have been investing with a risk of loss all along, but that does not mean you should seek a risky asset in retirement. This argues for an annuity, although the monthly payment you will receive depends on the age when you start the annuity. Generally, waiting until age 71, which is the last year when you must convert your pension plan into an income source, will result in meaningfully higher payments. However, most retirees tend to favour the LIF option, again because flexibility is favoured over the guarantee of income for the remainder of your or your spouse’s life.
Deferred Profit-Sharing Plan (DPSP)
The DPSP is a bit of a different animal among retirement accumulation schemes. Only the employer may make contributions. Employees are not permitted to contribute. There are restrictions against participation by significant shareholders, owners, partners, and their family members. The terms of the contributions will vary from employer to employer and may vary throughout an employee’s tenure with any one employer, depending on the profitability of the company. There is no mandate for a certain level of contributions unless specified in an employment agreement.
At retirement, the employee can:
- Withdraw the entire amount as cash, which would trigger withholding tax just as though you were to cash in your RRSP;
- Buy an annuity, essentially “pensionizing” your DPSP; or
- Transfer the assets to another registered plan, such as an RRSP (no additional contribution room is required to make this transfer), or if continuing employment elsewhere, potentially transfer it to another DPSP or registered pension plan, if permitted.
Among the reasons why an employee might be happy to see that a DPSP is being offered is that the employee does not contribute to the plan, nor are employer contributions to the plan considered a taxable benefit.
The group RRSP is virtually identical to a personal RRSP except that it is administered by an employer. From the employee’s perspective, there are at least two benefits to participating in a group plan. The first is that contributions are made automatically, deducted from each paycheque before tax is paid, resulting in an immediate tax deduction. The second is that in most cases, the employer will match the employee’s contributions. While employer contributions are a taxable benefit, the contributions themselves result in a tax deduction, offsetting the extra tax that would otherwise be payable.
As is the case with DC plans, one of the issues to contend with is the range of investment options available to the employee. The funds available may not be ideal, but the employer’s matching contributions are usually more than enough to counter that concern.
Each form of employer-based retirement income program has its advantages and limitations. In all cases, though, the good part in my view is that there is an incentive, or possibly a mandate, to participate in a program to save for retirement. If we exchange the term pillar for leg, you will recognize that a two-legged stool is not going to be very steady. That third leg of employer/personal savings and investments is exceedingly important for a stable income in retirement. It is even more important if you are finding it challenging to save for retirement on your own. Participating in a plan set up by your employer is a great way to overcome that problem and may make all the difference to you when you are no longer able or willing to work.
A great source for additional information on pension plans is Retire Happy, hosted by Jim Yih. Simply put in a key term in the search field and you will get a wealth of articles on the topic.
This is the 176th blog post for Russ Writes, first published on 2022-12-12.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.