Retirement savings have always been a significant concern for Canadians, so many employers introduced employee pension plans. The appeal is obvious, you and your employer contribute to the pension, and then you get paid a fixed income when you retire.
Unfortunately, pension plans have become increasingly expensive to maintain over the years, so some employers have had to make changes. The good news is that a pension in any form is still valuable, you just need to understand how they work to make smarter money decisions.
The different types of pensions
There are 2 kinds of pensions available: defined benefit and defined contribution. In short, a defined benefit pension is more valuable, but you have no say over which one you get as it’s determined by your employer. It’s also worth noting that not every company offers a pension. Here’s how the two work.
Defined benefit pension
Defined benefit pension plans are regarded so highly because you’re guaranteed an income when you retire. For example, the pension calculation might be 2% of your highest-earning years multiplied by years served. Now let’s say you worked for 30 years and your income topped out at $100,000. Your pension would pay you $60,000 a year when you retire. Both you and the employer would pay into the pension, but your company would be responsible for ensuring that you get your pay. Since defined benefit pensions are so expensive to maintain, many employers have switched or dropped them. That said, police officers, government workers, firefighters, teachers, and nurses still have them if they’re part of a union.
Defined contribution pension
With defined contribution pensions, both you and your employer still contribute, but the investing side is left up to you. How much you’ll get paid out when you retire will depend on how your investments have performed over the years. The amount you’ll get from your company depends on what they’re offering. For example, an employer might match your RRSP contributions up to 5% of your income. While a defined contribution pension isn’t as valuable as a defined benefit pension, your employer is still giving you free money as long as you join.
How is my pension managed?
Pension plan sponsors (your employer) will work with an investment firm that manages your money for you. For defined benefit pension holders, there’s nothing to do since your money is being invested automatically. For those with a defined contribution pension, the firm working with your employer will usually provide you with a list of funds you can invest in. The investment firms will take care of all the paperwork. They will usually provide you with a statement once a year, so you can see how your investments are doing. You can also contact the firm directly if you have any questions.
What happens to my pension if I quit my job?
Most pensions have a vesting period. For example, after two years, any contributions made by the employer are yours. If you quit before the vesting period, you would only get your own money back. Even if you’re not sure about how long you’ll be with a company, it’s always worth it to join the pension plan since you’ll never lose money. If your company has a defined benefit pension, it’s usually mandatory to enroll.
As for your money when you leave, you typically have quite a few options including:
- Leaving it in the plan and collecting your monthly payout when you retire
- Transferring the value of your pension to another pension plan if it’s allowed under your new employer
- Transferring the value of your pension to a Locked-In Retirement Account where you can manage the money yourself
- Transferring any non-locked-in funds to your RRSP
- Taking the cash value of any non-locked-in funds
How much does it cost me to join the pension plan?
The amount you contribute to a defined benefit pension plan is determined by the plan itself. You can not change this amount. While you won’t pay any fees or charges directly, the pension plan does have management costs taken from the pension fund.
With defined contribution funds, you can usually adjust how much you’re putting in. Let’s say your employer will match your contributions by 50% up to 10% of your income. That means you can adjust how much you’re putting in up to 10% whenever you like. The investments you choose have a management fee, but they’re usually lower than what you would pay if you were investing outside of a pension plan.
What are the benefits of joining the pension?
If you work for an employer with a defined benefit pension, joining will usually be mandatory. Even if you only have access to a defined contribution pension, you’ll be happy to join for the following reasons:
- Employers also contribute - Since all pension plans have an employer portion, you’re basically getting free money as long as you join. It’s like getting a raise without doing anything extra.
- They help you save for the future - A lot of Canadians struggle to save, but pension plans can be a forced savings method. Defined benefit pensions are usually mandatory, and defined contributions offer you an employer match, which is why you want to join.
- Low fees - Since pension plans pool the money with other people, the amount you pay in fees is much lower than individual investors. For example, the management fee is typically less than 1% for plan members, whereas it could be closer to 2.5% for non-members.
Are there any cons to pensions?
In most cases, no, but there are a few things to be aware of. Even though defined benefit pensions are guaranteed, there’s always a possibility that the company you work for goes bankrupt. If that were to happen, your pension could become worthless. That said, there’s a reason only certain employers offer defined benefit pensions now. They have a stable workforce where the odds of things going belly up are nearly impossible.
For defined contribution pension holders, you need to manage your investments on your own. You’ll technically be working with an investment firm, but it’s up to you to choose the funds that make sense for you. If you don’t do some basic research or make the wrong investment choices, your funds may not perform as well compared to average returns.
