Defined Benefit and Defined Contribution Pension Plans – What’s the Difference?

Planning for retirement is crucial, especially in a world where living costs continue to soar. Central to this planning are pension plans, which come mainly in two forms: Defined Benefit (DB) and Defined Contribution (DC) plans. This article takes a closer look at the intricacies of these plans, helping you make informed decisions for a secure future.

Understanding the Difference in Pensions

As mentioned, with the rising cost of living, having a financial cushion for your retirement is crucial. However, proper retirement planning can ensure that you maintain a comfortable lifestyle while also meeting unexpected expenses in your golden years.

Defined Benefit

A Defined Benefit (DB) pension plan is a type of retirement plan where the employer guarantees a specified monthly benefit to employees upon retirement. The benefit amount is predetermined, based on a formula usually considering factors such as the employee's salary, age, and years of service. Here are key points about Defined Benefit pension plans:

Guaranteed Monthly Benefit: The hallmark of DB plans is the guaranteed monthly income they provide in retirement.

Employer-Funded: Typically, employers are responsible for contributing to and managing the funds, although employee contributions may also be required in some plans.

Investment Risk: The investment risk in DB plans is borne by the employer, not the employees. It's the employer's responsibility to ensure that there are enough funds to meet the future pension obligations.

Benefit Formula: The retirement benefit is calculated through a formula, often based on the employee’s final or average salary, and the number of years they have worked for the company.

Inflation Protection: Some DB plans may offer protection against inflation, adjusting benefits to maintain purchasing power.

Lifetime Benefit: DB plans generally provide benefits for the lifetime of the retiree, and may extend benefits to the spouse or other beneficiaries after the retiree’s death.

Regulated: These plans are subject to governmental regulations to ensure their solvency and the protection of employees' benefits.

Limited Flexibility: Employees usually have little to no control over investment decisions or the ability to manage the funds.

Defined Benefit plans are often seen as more traditional pension plans, providing a level of financial security and predictability in retirement. However, they have become less common in the private sector in recent years due to their cost and the financial risk they pose to employers.

Defined Contribution

A Defined Contribution (DC) pension plan is a retirement plan in which both employees and employers contribute to individual accounts set up for each participating employee. Unlike Defined Benefit plans, the retirement benefits in a DC plan are not predetermined but depend on the contributions made and the performance of the investments chosen. Here are key aspects of Defined Contribution pension plans:

Individual Accounts: Each participant has an individual account, and the benefits are based on the amount contributed plus or minus investment gains or losses.

Contribution Rates: Both employees and employers can contribute, with the rates often being specified in the plan terms.

Investment Control: Employees typically have the flexibility to choose how their contributions are invested from a selection of investment options provided by the plan.

Investment Risk: The investment risk is borne by the employees, not the employer. The value of the account can fluctuate based on investment performance.

Tax-Deferred Growth: Contributions are usually made on a pre-tax basis, and investment earnings grow tax-deferred until withdrawal.

Withdrawal Terms: Participants can begin to withdraw funds without penalty at a specified age, usually 59 ½, and are required to start taking minimum distributions by age 72.

Portability: DC plans are often portable, allowing employees to roll over their assets to a new employer's plan or an individual retirement account (IRA) if they change jobs.

Employer Match: Some employers offer a matching contribution up to a certain percentage of the employee’s salary, which can significantly enhance the savings potential of the plan.

Lump-Sum or Annuity Options: Upon retirement, employees may have the option to take a lump-sum distribution or convert the account balance to an annuity, providing a regular income stream.

Defined Contribution pension plans are increasingly common as they shift the investment risk away from the employer and onto the employees and can be less expensive for employers to maintain. They also offer a level of individual control and flexibility that can be appealing to employees, particularly those who are financially savvy and wish to actively manage their retirement savings.

Which Pension Plan Is Better?

It is important to remember that there are no losers when given access to either of these plans.  Any pension is better than no pension.  With that in mind, DB plans are ideal for individuals seeking financial stability post-retirement, and due to the increased risk being shouldered by companies that offer them, they are increasingly hard to find.  Meanwhile, DC plans suit those willing to take investment risks for potentially higher returns.

RRSP, TFSA, and Pension Plans

For those with the means and foresight, planning for retirement should not end with contributions to a pension plan.  For example, as it stands, there are various other accounts available in Canada geared towards retirement savings.  These include primarily Registered Retirement Savings Plans (RESPs) and Tax-Free Savings Accounts (TFSAs).  When utilized alongside a pension plan, such investment vehicles can go a long way toward providing financial security for those over 65 years of age.  Essentially, diversifying retirement savings allows for greater financial flexibility and risk management.

Conclusion

Defined Benefit and Defined Contribution plans cater to different financial needs and risk tolerances. By understanding their workings, pros, and cons, individuals can better plan for retirement in an economically challenging environment, ensuring a secure and comfortable post-working life.

For Canadian investors interested in kick-starting their retirement savings journey, one of the best options around to do so is Questrade – Canada's largest online brokerage platform.

For a deeper dive into investment options, including RRSPs, and a comparison with other retirement saving instruments, visit securities.io to explore a wealth of resources available to Canadian investors.