A defined benefit pension plan is a considered an employer pension plan. These type of plans are set up on behalf of employees or a union in order to provide periodic payments in retirement. These plans are registered with the CRA and appropriate federal and provincial regulatory authorities. These regulatory authorities define the minimum standard of benefit that must be provided by an RPP to the plan members. There are two types of employer pension plans:
- Defined Benefit Pension Plan
- Defined Contribution Plans
Defined benefit pension plans, are the preferred choice for unions and employees as they promise a guaranteed monthly pension income in retirement. These type of plans are slowly being phased out as the plan sponsor assumes all the risk in making sure that this guaranteed monthly income in retirement is achieved.
Amount of Benefits
The benefit that plan members could receive in retirement is determined by a formula that considers several factors, such as, length of employment and salary history. Companies and plan sponsors have different type of formulas that they follow but below are three common formulas:
Pension Rules and Regulations
Under current pension rules and regulations, Defined Benefit Pension Plans may provide a pension benefit of up to 2% of earnings per year of service up to the following maximum amounts. (DB Limit)
| Year | MP limit | DB limit |
| 2020 | $27,830 | $3,092.22 |
| 2019 | $27,230 | $3,025.56 |
| 2018 | $26,500 | $2,944.44 |
| 2017 | $26,230 | $2,914.44 |
| 2016 | $26,010 | $2,890.00 |
1. Final Average Earnings Formula
The final average earnings formula is based on your average earnings leading up to retirement.
Benefit = Benefit Factor x Average Earnings x Number of Years of Pensionable Service
Example: Dave worked with TD Bank for over 25 years. His average salary over the last 5 years has been 60,000 a year. Using a benefit factor of 2%, what is his annual pension?
- 2% x $60,000 x 25 = $30,000
2. Career Average Earnings Formula
This formula is based on your average earnings throughout the time you were a part of the company’s pension plan.
Benefit = Benefit Factor x Average Earnings x Number of Years of Pensionable Service
Example:Mike worked with CIBC for over 30 years. His average salary over the 30 years was $55,000 a year. Using a benefit factor of 2%, what is annual pension?
- 2% x $55,000 x 30 = $33,000 per annum.
3. Flat Benefit Pension Formula
This is a formula that where your monthly pension benefit is determined by a fixed dollar amount for each year you were part of the plan
Benefit = Flat Amount x Number of Years of Pensionable Service
Example:John has been working with Scotiabank for the last 35 years and has been a plan member since he started. His benefit amount is $40 per year for each year he is a plan member. What would be his annual pension?
- $40 * 35 = $1400 per month.
- $1400 * 12 = $16,800 per annum.
Employers Bear Risk
In Defined Benefit Pension Plans, the employers have the risk and the responsibility in making sure that the employees receive the entitled benefit in retirement. This means that the employer bears the risk in making sure that the returns generated on the investment of employees will be enough. Due to this risk, defined benefit pension plans have high cost of administrations due to their requirement of complex actuarial analysis and insurance for guarantees.
Earliest Retirement Age with Unreduced Pension
Plan sponsors specify a “normal” retirement age, the age where a plan member can retire with a full pension in retirement. This age is typical 65. However, for many plans, it is not 65. The normal retirement age can be based on years of service with the the company and the member’s age, also known as the qualifying factor.Qualifying Factor + 85 Factor
- The qualifying factor is a formula which is used to determine whether a plan member is eligible for an unreduced pension, up to 10 years or more before the “normal retirement age”.
- The qualifying factor is usually 85 but it can be 80 or 90. Each company is different. The 85 factor is calculated by adding your age + years of pensionable service. If your age plus years of service equal to 85, you are entitled to unreduced pension in this example.
Age for Unreduced Pension
- To calculate the age of when a plan member is eligible to take early retirement, the formula is
Example: Steve is 50 years old. He has been a teacher for the last 30 years and joined the plan on his first day of work. The plan has a normal retirement age of 65, with a qualifying factor of 85. What’s the earliest age at which Steve can qualify for unreduced early retirement benefit?
Steve can retire with an unreduced early retirement benefit at 57 years and 6 months.
Integrated Pension Plans
Keep in mind that there are also defined benefit pension plan sponsors that incorporate the amount that an individual would receive from CPP/QPP into the final retirement benefit. This is known as an “integrated plan”. If a plan member does retire before 65, the “normal retirement age”, the pension benefit will likely be reduced to reflect CPP/QPP benefits.
Employer Contributions – Vesting
Keep in mind that the employer’s contributions are a tax deductible expense and are not a taxable benefit to the employee. The employer contributions are kept separate from the employee contribution for investment purposes. When an employer contributes to the plan, their contributions have to “vest” meaning that they’re not available until after a period of time, usually two years in most provinces.
However keep in mind that, in most jurisdictions, defined benefit pension plan and defined contribution pension plans may be automatically vested which will entitle the plan member to receive both the contributions of the employer and their own. Make sure you refer to your pension documents.
Employee Contributions
Employee contributions are tax-deductible during the year they are made. In comparison to a DC plan, employees are NOT responsible for making their own investment decisions.
Leaving the Plan Before Retirement
Before an employee can reap in the benefits of the employer’s contribution to the plan, they must make sure that the benefits have been “vested”. Once vested, the contributions are locked and can only be used for retirement purposes.
Leaving Before Vesting Period
If a plan member leaves or quits the plan before the vesting period has ended, they would be refunded all their contributions plus interest.
Leaving After Vesting Period
If a plan member leaves or quits after the vesting period, they have three options
- Take the deferred pension at their “normal” retirement age (65)
- Transfer the pension amount to their new employer’s pension plan if applicable
- Transfer the amount to a locked-in account such as a Locked In Retirement Account (LIRA) or Locked In Registered Retirement Savings Plan (LRSP)
Locked In Pension
- There are two significant advantages to having your pension benefits locked-in:
- You will have a regular income at retirement
- Creditors cannot seize locked-in pension money.
- Keep in mind that the money can be accessed if certain exceptions are met
Commuted Value
The commuted value of your pension is the lump sum present value of your expected future pension plus related benefits. The discussion of commuted value usually arises when the plan member is terminated, passes away or a breakdown in a conjugal relationship occurs. Note that a commuted value is only applicable in the context of a defined benefit pension plan.
As an example, let’s assume that a 50 year old plan member is terminated and he has to make a decision what to do with their commuted value. Leave it in the plan or take the commuted value.
A. Pension – An annual pension of $38,570 starting at age 55
B. Commuted value – A lump sum amount of $488,562.34
The plan members decision and course of action has different consequences.
Taking the Commuted Value
If a plan member elects the commuted value option, they would have to transfer this lump sum in a Locked-In Retirement Account, a Locked-In Retirement Savings Plan or purchasing an annuity. The individual or their advisor would be responsible in making sure that this lump sum amount is invested in a suitable product solution that would provide a stream of income in retirement.
Defined Benefit Pension Plan
The plan member could choose to leave the commuted value in the plan but they should be aware of the solvency ratio of the pension plan, especially if the company is private. A promise of a future pension is only as strong as the company itself. 100% solvency ratio means that the pension is funded and can meet its obligations. A plan member should also be aware if the pension is indexed to cost of living or inflation. The purpose of indexing is to help ensure that the member’s income increases with inflation.
Before you decide what option you should take, make sure you speak to a financial advisor in order to determine which choice is right for you.
Defined Benefit Pension Plan Options at Retirement
At retirement, plan members will be given pension documents stating the guaranteed life income that they’ll receive in retirement plus they’d have to make decisions on important issues. Below are two common key issues that defined benefit pension plan members might encounter.
Single vs Joint Pension
Under current pension legislation, your spouse has a right to your pension which as a result, you pension will be defaulted to a “joint-pension” with survivorship. If you were to pass away during retirement, your spouse would be entitled to a receive a certain percentage of your pension. You would have the option to decide what percentage this would be. (100%, 75%, 60%, 50% etc). Joint pensions usually pay a lower amount than single pensions. Spouses can waive their right to the joint pension by signing a waiver in which it will default to a single pension with a higher amount.
Guarantee Period
In a defined benefit pension plan, you will have the option to select your guarantee period. The guarantee period, 5, 10 or 15 years mean that your payments are guaranteed for at least that long, even if you die before the guarantee period ends. The longer the guarantee period, the lower the annual income will be. Your decision should be based on your expected life expectancy.