Defined Benefit Pension Plans
A defined benefit pension plan is a pension plan that guarantees employees a specific monthly benefit at retirement. It does not define the cost to the plan sponsor. The cost of the plan is determined by the amount employees contribute and the amount the investments earn. Any shortfall in the plan must be funded by the plan sponsor.
The amount of the benefit is known in advance, usually based on factors such as age, earnings, and years of service. The employer has the obligation to make contributions necessary to fund the promised benefit. These contributions "vest" (become the property of) the employee after a certain period (two years in many provinces). An annual actuarial valuation of the assets and liabilities of the plan determines the required contributions by the employer. These contributions are supplemented by revenues gained through the investment of the plan assets. The employer bears the investment risk and normally the investments are made by professional money managers.
Employees may or may not be required to contribute to the plan, depending on the plan's design. In some cases, employers set up a defined benefit plan for the employer contributions and a defined contribution pension plan, or a group RRSP. for the employee contributions. These plans are called "combination plans." The employer's contributions are a tax deductible expense and are not a taxable benefit to the plan member.
The amount of retirement benefit may be defined by one of the following formulas:
Career Average Earnings
A pension benefit formula that determines the benefit by multiplying a certain percentage (up to 2%) of the average earnings by the years of service (i.e. monthly pension = 1.5% x average monthly earnings x years of service).
For example, assume that the employee earned an average of $30,000 per year during his career. If the employee worked for 30 years for that employer and was a member of the pension plan for all of those 30 years, the benefit that this employee would receive at normal retirement age would be: $30,000 x 1.5% x 30 = $13,500 per year.
A pension benefit formula that determines the benefit by multiplying a certain percentage (up to 2%) of the final average or best average earnings for a stated period before retirement by the years of service (i.e. monthly pension = 2.0% x average monthly earnings of last 5 years x years of service).
For example, assume that the employee earned an average of $40,000 per year for the last five years. If the employee worked for 20 years for that employer and was a member of the pension plan for all of those 20 years, the benefit that this employee would receive at normal retirement age would be: $40,000 x 2% x 20 = $16,000 per year.
A pension benefit formula that determines the benefit by multiplying a certain amount of benefit by the years of service (i.e. monthly pension = $50 monthly x years of service).
For example, assume that the employee worked for 25 years for the employer and was a member of the pension plan for all of those 25 years, the benefit that this employee would receive at normal retirement age would be: $50 x 25 = $1,250 per month.
The pension definition varies between employer plans. The benefits may be higher or lower than the above examples.
Forms of Pension
A normal form of pension must be specified in the pension plan. This generally includes a life annuity with a guarantee period (e.g., payments for life of the plan member for a minimum of 10 years). The majority of Pension Benefit Acts require that the pension be a joint and and last survivor pension that provides a pension for the life of the retiree and his/her spouse. These "acts" generally permit a reduction after the first death (within specified limits). If a joint and last survivor option is not chosen, both the member and spouse must sign a "Spouse's Waiver of Rights Under a Pension Plan" form.
Advantages of a Defined Benefit Pension Plan:
- Benefit is known and guaranteed
- Time to invest is not as crucial a factor in determining the benefit for older employees
- Benefits for older employees may be higher than under a Defined Contribution Pension Plan
- Plan deficits must be funded solely by employer (advantage to employee)
- Contributions are tax deductible to the employer
- Contributions are not taxable to the plan member
- Employee contributions can be made by payroll deduction
- Past service benefits are possible
Disadvantages of a Defined Benefit Pension Plan:
- Difficult to understand and communicate
- Generally no participation by employees in investment decisions
- Actuarial evaluations of plan required
- Costs to employer are difficult to predict
- Potential for problems with pension surplus and over funding
- Plan deficits must be funded by employer
- Higher administration costs