A defined benefit (DB) pension plan is a type of group retirement savings plan that gives employees a set monthly income in retirement. While these plans are now rare in the private sector, they’re still common in the public sector and some unionized jobs.
Read on to learn everything about DB pension plans, including how they work, their pros and cons, how to maximize your benefits, and key considerations for retirement planning.
What is a Defined Benefit Pension Plan?
A defined benefit pension plan guarantees a specific amount of retirement income determined by a set formula. This formula factors in the employee’s salary, years of service, and a benefit multiplier.
Unlike defined contribution plans (DCPP), where employees take on the investment risk, DB plans put the responsibility on employers to make sure there’s enough money to pay out the promised pensions. To achieve this, employers contribute based on calculations made by actuaries – financial professionals who specialize in managing risk and uncertainty. Employees may also be required to contribute a percentage of their salary to the plan.
The primary advantage of DB pension plans is that they provide a predictable retirement income that lasts for life. This means employees don’t have to worry about making investment decisions or outliving their savings in retirement.
How Does a Defined Benefit Pension Plan Work?
Understanding how DBPP works can help you get the most out of your retirement benefits. Here are the key details on how DB plans function:
- Benefits formula: The monthly pension amount is not based on investment returns but on factors like salary history and years of plan membership. We will explore these factors below.
- Shared contributions: Both the employer and employee contribute a percentage of the employee’s salary to the pension plan to fund future benefits.
- Assets held in trust: All DB contributions are pooled into a pension trust fund and invested by professionals to grow the funds available to pay pensions.
- Employer-funded: The employer is responsible for ensuring the pension plan has sufficient assets to meet its pension obligations. If investment returns are low, the employer must make up the shortfall.
- Actuarial valuations: An actuary must perform a valuation at least every 3 years to assess the plan’s funded status and determine the required contribution level to keep it sustainable.
- Lifetime payments: Upon retirement, the plan provides monthly pension payments for the rest of the employee’s life.
- Spouse and Survivor Benefits: DB plans offer valuable benefits to surviving spouses after the plan member’s death.
- Legal framework: Defined benefit pensions are governed by federal and provincial laws that require standards for funding, benefits, survivor protections and professional administration.
In summary, DB plans provide a guaranteed income in retirement, with employers responsible for funding the plan and managing investments to support the promised benefits.
Who Typically Offers Defined Benefit Pension Plans?
In the past, DB pension plans were common among large companies and unionized workforces. However, they have declined dramatically in the private sector over the last 30 years. DB plan membership is now concentrated in these sectors:
- Public sector – Federal, provincial, municipal governments and agencies
- Crown corporations – Examples include Hydro One, Ontario Power Generation, and Canada Post
- Unionized industries – Particularly in sectors like education, healthcare, manufacturing, transportation, and construction.
- Large corporations – mainly long-established companies.
The trend has been for private sector employers to shift to defined contribution plans, which have lower costs and risks for the employer.
Part-time and contract employees may still be eligible for DB plans, depending on the employer. The eligibility rules can vary. Public service plans often require 2 years of continuous, full-time service.
How Does the Defined Benefit Pension Plan Calculate Retirement Income?
There are three main types of formulas used by DB plans to calculate your future monthly pension payment:
Final Average Earnings
This is the most common formula for public sector plans, based on the employee’s earnings close to retirement, usually the average of their highest consecutive 5 years of salary.
For example, if you had 30 years of plan membership, your highest average salary during your final five working years was $80,000, and the benefit percentage is 2%, the annual pension would be:
- 2% x $80,000 x 30 years = $48,000/year
A higher final average salary will result in a greater pension. So, working longer to increase your highest earnings years can pay off.
Career Average Earnings
This formula bases the pension on the employee’s average earnings over their entire career. It generally results in a lower pension than a final average earnings formula if your salary increased steadily over time.
For example, if the benefit percentage was 2%, multiplied by career average earnings, and an employee had average earnings of $60,000 over a 30-year career, their pension would be:
- 2% x $60,000 x 30 years = $36,000/year
Under this formula, an employee with steadily increasing earnings throughout their career would receive a lower pension than under a final average earnings approach.
Flat Benefit
This formula provides a fixed dollar pension amount for each year of plan membership.
For example, $65 per month for each year of service. An employee with 25 years of service would receive:
- $65 x 12 x 25 years = $19,500/year
The flat benefit is easy to understand, but it does not account for the employee’s actual salary. Lower and higher earners receive the same pension per year of service.
Some DB plans provide guaranteed cost-of-living increases to pensioners’ payments annually after retirement. This helps offset inflation and maintain the purchasing power of the pension over time.
The Potential Drawbacks of Defined Benefit Plans
Besides many advantages that the DB pension plan offers, it also comes with trade-offs to consider. You should be aware of the following downsides to plan accordingly.
- Risk of underfunding – If investments underperform or the employer goes bankrupt, full benefits may not be paid.
- No control over assets – You cannot choose how funds are invested.
- Lack of portability – DB pensions are tied to the employer, making job changes more complex.
- Complex calculations – Formulas for contributions and benefits can be difficult to understand.
- Long vesting periods – You may lose benefits if you leave the employer before fully vesting, which is often 2 years or more.
- Limits the ability to realize lump sum – Commuted values or transfers are restricted, especially nearing retirement.
- Continued workforce participation – Workers may stay in jobs longer only to maximize their pension amount.
As you approach retirement, it’s important to weigh these pros and cons relative to your personal financial situation and retirement goals.
Defined Benefit vs. Defined Contribution Pension Plans: What’s the Difference?
While both types of registered pension plans offer advantages like tax-deferred growth, DB and DC plans differ significantly in how benefits are determined and risks are allocated. This table summarizes six key differences:
| Defined Benefit (DB) Plan | Defined Contribution (DC) Plan | |
| Philosophy | Provide a guaranteed retirement income. | Help accumulate retirement savings. |
| Contributions | Both the employer and employee contribute a percentage of their pay. Employer contributions fund at least 50% of benefits. | Employee and employer contribute a percentage of pay to the employee’s account. |
| Investments | Professionals manage investments in a pension trust fund. | Individuals choose from investment options for their accounts. |
| Retirement Income | Based on a formula using salary and service. Guaranteed payments for life. | Balance of account is used to buy an annuity or transferred to an RRIF. Income depends on account balance and rates. |
| Risk | The employer bears the funding and investment risk. | The individual bears the investment risk. |
| Benefits | Often include inflation protection, early retirement, and disability income. | Additional benefits can be purchased, but they reduce retirement income. |
That said, the key advantage of DB plans is that they provide predictable, guaranteed lifetime retirement income, compared to DC plans, where the individual assumes the investment risk.
What Happens If You Leave a Defined Benefit Pension Plan Before Retirement?
If you terminate your employment before retirement age, you have some options for your accrued DB pension benefits. Your choices depend on your age and provincial regulations.
If you’re under age 55, the options include:
- Deferred Pension – Leave your benefit in the plan to start receiving a monthly pension at your normal retirement age, typically 65.
- Transfer value to LIRA – Transfer the commuted value representing the lump sum current value of your future pension to a Locked-In Retirement Account (LIRA).
If you’re over age 55, more flexible options may be available, depending on your plan:
- Immediate reduced pension – Start receiving reduced monthly pension payments right away.
- Transfer value to annuity – Use the commuted value to purchase an annuity from an insurance company. The commuted value is the lump-sum amount of money that would be needed today to generate your future guaranteed pension payments.
- Transfer service to another DB plan – You may be able to transfer your years of service to another DB plan you join if a reciprocal transfer agreement is in place.
Most DB plans have vesting periods before you are entitled to benefits if you leave the plan. Two years is typical. If you leave prior to vesting, you will receive your contributions back with interest, but you will lose the employer contributions.
What Survivor Benefits Do DB Plans Provide?
Defined benefit (DB) pension plans offer valuable benefits and income protection for your surviving spouses and common-law partners after a plan member passes away.
If You Die Before Retirement
Your surviving spouse can receive lifetime payments, which are often the commuted value of your pensions. Or the spouse can transfer the pension to a locked-in account or annuity. This provides financial support for the spouse after losing the plan member.
At the time of Retirement
DB pensions normally pay out as a joint and survivor pension to protect the spouse. This means that after you die, a portion of your pension will continue to be paid to your surviving spouse. Pensioners can opt for 100% survivor benefits, but this reduces the pension amount during the retiree’s lifetime.
Tips for Maximizing Your DB Benefits
Here are nine key strategies DB plan members may want to consider to maximize their retirement benefits:
- Start contributions early – The earlier you begin contributing, the more your benefit accrues.
- Consider buying back service – Making up missed contributions from past years of eligibility increases your pension.
- Change jobs strategically – Target employers offering DB plans to accrue benefits.
- Coordinate with other retirement income – Plan how your DB pension will work alongside your Canada Pension Plan (CPP), Old Age Security (OAS), and personal savings (RRSPs, TFSAs). Remember that you can take CPP as early as 60 or as late as 70.
- Choose survivor benefit carefully – Balance providing for your spouse with your own needs to decide what’s best for your family.
- Seek professional advice – Get help deciding between lifetime pension income and commuted value payout.
The bottom line
DB pension plans are the key part of retirement security for millions of Canadian workers, especially in the public sector. With proper planning, you can take full advantage of your DB pension plan as an integral part of your long-term financial strategies.
FAQs related to the Defined Benefit Pension Plan
What happens if a DB pension plan becomes underfunded?
If a DB plan's investments underperform, the employer is legally obligated to make additional contributions to make up the shortfall. The plan actuary determines the required top-up payments needed to restore full funding over time.
Where are the assets held in a defined benefit pension plan?
The assets of a DB plan are held in a pension trust fund. The funds are managed by professional investment managers to generate returns needed to pay the plan's pension obligations.
When can you start receiving CPP benefits if you have a DB pension?
Many DB plans allow early retirement before age 65. This permits coordinating CPP benefits with your DB pension as early as age 60 for an integrated retirement income.
Do DB pension payments increase with inflation?
Some DB plans provide guaranteed cost-of-living adjustments to pensioners' payments annually. However, not all DB plans have this inflation protection.
Is a defined benefit pension plan better than a defined contribution plan?
DB plans provide guaranteed lifetime retirement income, while DC plans have uncertainty about future benefits. But DB plans also come with risks like underfunding.
What happens to my DB pension if I die?
DB plans provide important benefits to surviving spouses after a plan member's death, such as minimum 60% lifetime pension payments.
