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.
Defined benefit plans are designed to provide you with a specified amount of pension benefit when you retire based on a formula. Generally, this formula depends on factors like years of service and earnings and is described in the pension plan documents provided to members. Members of this type of plan are advised annually of the amount of pension benefit they have earned or “accrued” up to that point.
There are three types of benefit formulae commonly used to determine a member’s pension:
For each year of service, the formula provides a fixed percentage of your final earnings from employment or of an average of your earnings over a fixed period of time. In other words your pension adjusts in step with your wages.
For example: 1.6% of your average earnings over the best 5 years of earnings x your total years of service.
Your annual pension benefit is a fixed percentage of your annual earnings while a member of the plan.
For example: 1.2% of your annual earnings.
Your annual pension benefit is a fixed dollar amount per year of service.
For example: $32 a month per year of service.
In a defined contribution or money purchase pension plan, a specified amount of money is contributed regularly for you. This money is placed in an investment account in your name. At retirement, these contributions- plus interest- are used to purchase a pension. You will not know the amount of pension you will receive until you retire.
Some defined contribution plans permit employers to make their own investment choices, while others provide that the employer or board of trustees is responsible for all investment decisions.
Ultimately, the size of your pension depends on the amount of the contributions made by, or on behalf of you. It will also vary due to the return on the investment of those contributions. Annuity rates (i.e. long-term interest rates) at the time of retirement also may be a factor.
The traditional form of pension is the life annuity. Typically with a life annuity, your locked-in pension money is paid to a life insurance company that guarantees the payment of a fixed amount for your lifetime. Pension legislation has introduced the following alternatives to the life annuity:
Upon transferring locked-in pension funds to a LIF at retirement, an individual will receive an adjustable flow of retirement income, subject to an annual minimum and maximum withdrawal amount. The withdrawal range is calculated so that there is enough money in the fund to ensure that the individual receives an income for their lifetime. It is important to note that many of the rules that apply to RRIFs also apply to the LIF.
A Variable Benefit, which is similar in nature to the above RRIF may be offered by a defined contribution plan. Check with the administrator of your plan to see if this is a retirement option under your plan.
A Registered Retirement Income Fund (RRIF) will allow you to determine your level of income, as well as manage your pension capital to take advantage of continued capital growth from investment earnings, and to have more flexibility for tax and income planning purposes.
Robin Muir, CFP®, CLU®, CH.F.C.