Defined Benefit vs. Defined Contribution Pensions

Posted 03 Sep 2015 by Melissa Allan

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Pensions have traditionally been a common element of many retirement plans, but the type of pension plays a big part in piecing together your retirement income plan:

Defined Benefit (DB) Pension Plans

A Defined Benefit (DB) pension plan provides a retirement income based on a formula that is a combination of years of service and salary. These plans are typically offered by government and some private sector employers. An example would be an employee who retired after 20 years of full-time service. The retirement income might be based on a formula of 2% per year of service multiplied by the best 5-year average earnings over their career. If the best average 5-year salary was $80,000 then the pensioner could expect to receive a pension of $32,000 a year (20 x 2% x $80,000).

Advantages:
  • These plans put most of the investment risk on the employer;
  • Regardless of market performance, the pensioner’s income is guaranteed;
  • Typically most DB pension plans have been indexed to inflation based on the Consumer Price Index, though this is changing with many employers eliminating indexing or introducing discretionary indexing dependent on the funding level of the plan.
Disadvantages:
  • The survivor benefit could be nil or very low. Depending when the retiree dies, they may have been better off in a defined contribution pension plan;
  • There is normally a vesting period, meaning if the employee leaves the employer within a certain period, the employer’s contributions into the plan remain with the employer.
Defined Contribution Pension Plans

A Defined Contribution (DC) pension plan has a defined contribution during the employment years. An employer matches an employee’s contribution up to a certain level (for example 5% of salary).

Advantages:
  • Total control over the investments within the plan;
  • If an employee/retiree died, the full amount of the plan is transferred to a surviving spouse if applicable or paid out to the named beneficiary. The defined benefit plan only pays out a portion.
Disadvantages:
  • The employee carries most of the risk. If they choose poor investments, the outcome may not be what they had hoped for;
  • The investment choices within these plans are typically limited, meaning a small number of investments to choose from;
  • The plan administrator may offer little investment advice on what investments to choose.
The Decline in Popularity of Pension Plans

Statistics Canada shows that the number of pension plans are declining in Canada. In general, unless you expect to be with the employer for less than the vesting period, we recommend taking advantage of an employer offered pension plan. We often review the employee options within the plan to help ensure full understanding of the plan because features such as the survivor benefit, indexing, and investment choices are extremely important.

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