How do employee pension plans work?
By Kevin Press
Defined benefit, defined contribution, group registered retirement savings plan — the list goes on. Here’s what you need to know.
To be employed by an organization that provides one or more retirement savings plans to its people is one of the greatest financial advantages you can enjoy in Canada. These plans come in a variety of shapes and sizes, but they all share one thing in common: They help you achieve your retirement savings goals.
But employer-sponsored plans can be complicated, and often difficult to understand. I’m planning two posts to help. Today’s entry covers employee retirement savings plans; the next will focus on employee benefit plans. My goal is to answer key questions and perhaps dispel a myth or two while I’m at it.
What kinds of employee pension plans are there?
There are two basic kinds of plans: defined benefit plans and defined contribution (sometimes called capital accumulation) plans.
Defined benefit plans provide members (pension-speak for employees who participate in the plan) with a level of retirement income based on a calculation that typically factors in years of service to the employer and salary earned. The member may make contributions to the plan during his or her time with the organization. Employer and member contributions are pooled, and invested on the plan’s behalf. The plan sponsor is responsible for ensuring that it pays members the retirement income they’re entitled to.
Defined contribution plans allow organizations to sponsor plans without bearing the investment risk inherent in a defined benefit plan. Each member has his or her own account. Employer and member contributions are invested, usually based on investment options selected by the member. Your retirement income is determined by how your investments perform. Defined contribution pension plans, group registered retirement savings plans, employee share purchase plans, deferred profit-sharing plans and group tax-free savings account plans are all examples of defined contribution schemes.
What role does my employer play in the plan’s management, and who else is involved?
Some employers manage their plans in-house, but this is less and less common. Typically, plan sponsors rely on a range of organizations that include plan administration providers, investment managers, life insurance companies, trust companies and consultants.
Plan administration providers supply record-keeping and a range of other services to defined benefit and defined contribution plan sponsors. Investment managers, obviously, invest the assets on behalf of defined benefit plan sponsors and defined contribution plan members. Insurance companies provide plan administration and other services. Trust companies provide what’s called custodial services, such as trade processing. Consultants support plan sponsors with key functions such as plan design, member communications and service provider selection.
What happens if I leave my employer?
If you’re leaving a plan for any reason, talk to a financial advisor. You have options, many of which are complex.
After a short period of time in the plan — two years is typical — defined benefit and defined contribution pension plan members are considered “vested.” This means they are entitled to receive the benefits of the plan at retirement. If you leave a plan before this time, you receive no benefit (except the value of your own contributions). If your benefits are vested, you have a number of options, depending on how the plan is designed. You can:
- Leave your assets in the plan you’re exiting. The plan sponsor will tell you what level of retirement income you are due.
- Transfer pension credits or dollars to another pension plan, if you’re joining one.
- Transfer your assets into a registered retirement savings plan.
- Transfer your commuted value (the amount required to pay you the level of retirement income owed to you by the plan you’re leaving) into a locked-in plan, which means you can’t withdraw the money until retirement.
- Take the cash, in the case of the profit-sharing plans (you may have to pay tax on this).
Do I pay a fee to participate in a plan?
Defined benefit plan members do not pay fees directly. Their retirement income is calculated based on years of service and salary earned.
Defined contribution plan members may pay fees for investment management, plan administration and other services. These fees are typically low compared to those charged to retail account holders outside an employer-sponsored plan.
What are the advantages of being a member of an employer-sponsored plan?
Three important advantages of workplace pensions and savings plans:
- Lower (or no) fees, as just described. The average equity mutual fund in Canada carries a management expense ratio of about 2.4%. Defined contribution plan funds charge lower fees generally, often below 1%.
- Employers often make contributions to both defined benefit and defined contribution plans. You have to participate, though, so choosing not to join a plan can be like saying no to free money.
- Plans require you to save. It’s hard to set aside money every month, so retirement savings plans provide a valuable source of discipline. Defined contribution plan members benefit from dollar cost averaging when markets are down, too. By investing a set amount on a regular basis, you’re able to buy more when prices are lower. That can benefit you in the long run. This effectively removes a lot of the emotion from your investment decisions.