Defined Benefit Pension Plan (DB) Canada: How Benefits Are Calculated

A defined benefit (DB) pension plan is a type of group retirement savings plan that gives employees a set monthly income in retirement.

While DB pension plans have become less common in the private sector, they remain widely used in the public sector and many unionized workplaces across Canada. The exact benefits you may receive depend on your specific plan rules and applicable pension legislation.

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 retirement income depends on investment performance, DB pension plans generally place the investment and funding responsibility on the employer. As a result, employees are not required to make ongoing investment decisions as part of the plan, although they may still be required to contribute a portion of their salary.

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: In many DB plans, both the employer and employee contribute a percentage of the employee’s salary, although some plans are fully employer-funded.
• 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: Regular actuarial valuations are required under applicable federal or provincial pension legislation, typically at least every three years, and in some jurisdictions more frequently.
• 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, defined benefit pension plans provide predictable retirement income, with employers responsible for funding the plan and managing investment risk on behalf of employees.

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.

Eligibility for a defined benefit pension plan varies by employer and plan design. In many public sector plans, employees become vested after two years of plan membership, while participation rules for part-time or contract employees depend on specific plan terms.

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.

Many defined benefit pension plans in Canada are integrated with the Canada Pension Plan (CPP). This means the pension benefit may be higher before age 65 and reduced once CPP benefits begin, while total retirement income remains relatively stable.

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 a pension plan becomes underfunded due to investment performance or employer financial challenges, benefits may be affected in certain circumstances, depending on funding levels and regulatory protections.
• 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 must meet minimum vesting requirements before becoming entitled to pension benefits. Vesting rules vary by jurisdiction and plan design.
• 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:

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 leave your employer before reaching retirement age, you may still be entitled to benefits you have earned under a defined benefit pension plan. The options available depend on factors such as your age, length of plan membership, the plan’s rules, and applicable pension legislation.

If you are below the plan’s early retirement age, your options may include:

• Deferred Pension – You may be able to leave your benefit in the pension plan and begin receiving a monthly pension at the plan’s normal retirement age, which is often around age 65 but varies by plan.
• Commuted value transfer – Transfer the commuted value, the present value of your future pension, to a Locked-In Retirement Account (LIRA), subject to plan rules and regulatory limits.

If you are eligible for early retirement under your plan, additional options may be available, such as:

• Early or reduced pension: You may be permitted to start receiving monthly pension payments earlier than the normal retirement age, with benefits typically adjusted to reflect the longer payment period.
• Annuity purchase: Use the commuted value, where allowed, to purchase an annuity through a locked-in retirement vehicle.
• Service transfer: In some cases, pension service may be transferred to another defined benefit plan if a reciprocal transfer agreement exists.

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. The specific benefits available depend on the plan’s rules and applicable pension legislation.

If death occurs before retirement

If a plan member dies before starting their pension, survivor benefits are typically payable to an eligible spouse or common-law partner.

Depending on the plan and provincial pension rules, the survivor may be entitled to receive the commuted value of the member’s accrued pension. In some cases, this value may be paid as a lump sum or transferred to a locked-in retirement vehicle, such as a Locked-In Retirement Account (LIRA) or an annuity, subject to regulatory requirements.

At retirement and after

When a member retires with an eligible spouse, DB pensions typically default to a joint and survivor pension. After the pensioner’s death, a portion of the pension, often at least the legislated minimum, continues to be paid to the surviving spouse.

In some plans, retirees may choose a higher survivor benefit, such as 100%, if available, which usually results in a lower pension amount during the retiree’s lifetime.

Tips for Maximizing Your DB Benefits

Here are six key strategies DB plan members may want to consider to maximize their retirement benefits:

• Start plan membership early – Earlier participation allows you to accumulate more years of pensionable service, which can increase your future pension benefit.
• Consider buying back service – If permitted, purchasing eligible service from prior periods may increase your pension, although costs and eligibility vary by plan.
• Understand the impact of job changes – Because DB pensions are tied to years of service, vesting rules and portability options should be considered when changing employers.
• Coordinate with other retirement income – Consider how your DB pension will work alongside the Canada Pension Plan (CPP), Old Age Security (OAS), and personal savings such as RRSPs and TFSAs.
• Review survivor benefit options – Survivor benefits and joint pension options can affect both retirement income and financial protection for a spouse.
• Seek professional advice – Pension and financial professionals can help explain complex options, including lifetime pension income versus commuted value decisions.

These considerations are general in nature and may not apply to all defined benefit pension plans.

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.

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